Reverse mortgages are home mortgages that work in the opposite way to a normal home mortgage. Instead of interest and capital being repaid over a fixed term, there are no repayments. Rather interest is capitalised until repayment which takes place when either the home owners sell the property or the home becomes vacant because the owners have either died or moved into an aged care facility. Most lenders allow earlier repayment of loans, although early repayment fees may apply.
This type of loan has appeal to older people who are asset rich but cash poor. It can be used to supplement cash flow for lifestyle purposes or to fund accommodation payments where one member of a couple moves into an aged care facility and the spouse remains in the home. The loan can be taken as a lump sum, a regular income stream, a line of credit or a combination of these options.
To ensure a reverse mortgage is a limited recourse facility, it’s important the loan agreement includes a no-negative equity provision that limits liability to the value of the property. This is important as the capitalisation of interest increases the outstanding loan balance over time.
On 18 September 2012, the Federal Government introduced a statutory ‘negative equity protection’ on all new reverse mortgage loans to ensure lenders providing limited recourse reverse mortgages cover this risk by imposing a conservative loan to value ratio.
How much can you borrow?
As a rule of thumb, the older you are the more you can borrow, as the reduced life expectancy offsets the impact of capitalisation of interest on the outstanding loan balance overtime.
As a general guide, you need to be at least age 60 to borrow and the loan limit is likely to be 15-20% of the value of the home. This increases by 1% per year of age above 60.
ASIC’s MoneySmart website contains useful information on likely costs and other aspects of reverse mortgages. It includes a reverse mortgage calculator to illustrate the effect a reverse mortgage may have on the level of equity in the home overtime, plus the potential impact of interest rates and house price movements.
Social security treatment
An attraction of reverse mortgages is the favourable treatment they receive from both the Department of Social Services and the Department of Veterans’ Affairs when means testing eligibility for benefits. Where the loan (which for means testing purposes are referred to as home equity conversion loans) is drawn down as a lump, the first $40,000 if unspent (e.g. if deposited into a cash account) is an exempt asset for a period of 90 days. If after that time it has not been spent, it becomes an assessable asset. Whilst exempt under the assets test for a period of 90 days, the $40,000 is subject to deeming under the income test from day one.
Amounts drawn down are not treated as income, instead being subject to the deeming rates if unspent. This treatment is pursuant to Section 8(4) and 8(5) of the Social Security Act 1991 (SSA) which exempt the first $40,000 of the loan from the income test and Section 8(11) of SSA which exempts amounts in excess of $40,000 from the income test.
Amounts drawn down are also exempt from the aged care means test (asset test portion) that is used to assess whether a resident is required to contribute towards the cost of their accommodation and medical care.
Structuring a reverse mortgage loan as regular drawdowns to fund living expenses rather than a fully drawn loan at the outset, has the dual benefit of minimising the impact of the capitalisation of interest and avoiding a reduction of age pension entitlements.
What are the benefits of a reverse mortgage?
- Ability to access home equity, without selling the property to supplement cash flow for living expenses.
- Potentially favourable treatment under social security and aged care means testing.
What are the risks of a reverse mortgage?
- Interest rates are generally higher than average home loans.
- If the interest rate is fixed, the break costs to terminate the loan may be high.
- Debt can increase at a reasonable rate due to capitalisation of interest (especially if variable in times of rising rates) which reduces the amount available to leave as an inheritance.
- Similarly, if the loan has been taken out for current life style needs, this will reduce the remaining equity available to fund future needs such as aged care accommodation payments.