Reverse Mortgages: Defining Characteristics
Reverse Mortgage loans have three defining characteristics:
No mandatory payments are required until a trigger event occurs. Trigger events can include death of the owner/s, sale of the property, the last borrower vacating the property, or breach of certain clauses of the contract.
There is generally no set or fixed term. These loans continue until the last surviving borrower dies or a trigger event occurs.
Interest is charged and compounded over the life of the loan.
Under the Responsible Lending principles of the National Consumer Credit Protection Act, qualifying applicants can borrow up to specified margins against the security of their primary residence. In some cases these loans may be secured against non-owner occupied properties.
While this type of loan can never be in default due to lack of payments being made, other conditions of the loan can place it in default. These include not maintaining the property to a satisfactory standard. In this case the lender may have the right to have the maintenance done with the cost being added to the balance of the loan.
To qualify, applicants must be of a minimum age – commonly 65 years (though some lenders will consider 60 years and above). Where there is more than one borrower, the age of the youngest person determines their eligibility. The amount of the loan available varies depending on the provider. The basis for calculating the amount borrowed firstly depends on the age of the applicant. Generally the older the applicant the more they can borrow.
Secondly, the value of the property to be offered as security determines the maximum size of the loan. The Loan to Valuation Ratio (LVR) is the amount advanced against the value of the secured property. The maximum LVR can be as a high as 45%.
The minimum loan amount depends on the provider. It can be as little as $10,000. Applicants must own the property. If there is an existing mortgage on the secured property it must be repaid in full. This allows the reverse mortgage provider to have the only mortgage over the secured property.
It is usually necessary to have the property revalued periodically. The cost of this may be borne by the consumer or added, at the time of valuation, to the loan. While eligibility may be satisfied in respect of the age of the intending borrowers, restrictions due to the location of the proposed secured property may result in a loan not being offered.
Compound Interest and Other Costs
The interest rate charged is usually above the market’s standard variable home loan rate. It is generally calculated daily and charged monthly (compounded). Therefore, the debt increases over time. Other costs can include application fees, monthly account fees and valuation fees. These are usually added to the loan balance on which interest accrues and compounds.
For example, a person borrows $30,000 gross (including application fee) at an interest rate of 8.5% per annum and a monthly charge of $10. At the end of 10 years the debt would have grown to about $71,860. This assumes the interest rate remains constant – a big assumption as usually a variable interest rate applies.
Legal fees may also apply to cover legal advice which is required by the equity release provider.
If desired, it is possible to make voluntary repayments which will effectively reduce the amount of debt that accrues. Payments made on fixed rate loans may incur a break fee.
Other assumptions that need to be made could include the potential value of the property over time and the cost of maintenance. These can be particularly important where it is the borrowers desire to leave a legacy.
It is sometimes possible to have a protected amount of equity which can be left as a legacy. This will restrict the amount that can be borrowed. Applicants should check the terms and conditions of this option with their provider.
Prior to making an application for a loan it is important to check if an application or establishment fee is payable even if the loan is not proceeded with.
Break fees may apply if the loan is repaid early or a payment is made during a period when the interest rate is fixed. The interest rate may be fixed for a specified term or for life. Where the rate is fixed for life, repayment of the loan prior to the death of the borrower/s could result in the fee being charged.
In general, if rates at the time of repayment are lower than the contracted fixed rate for the loan the break fee could be a significant amount. They depend on the remaining term of the loan, the contracted interest rate and the current rate at the time of payment/repayment. Break fees will not apply if repayment occurs due to the death of the last borrower/occupant or moving into assisted aged care. It usually applies if the property is sold early or the loan is being refinanced.
Although amendments were made to the ‘National Consumer Credit Protection Act 2009′ that prohibits early termination fees for most residential loans, they do not include a credit fee or charge that is a ‘break fee’. A break fee should only reflect the actual loss or cost incurred by the lender due to early termination. Fees cannot be charged to discourage or punish the borrower. It is prudent to ensure that the process for calculating a break fee is fully understood and examples are given.
Methods of calculating the break fee varies between providers so it would be prudent to ensure the process has been explained and examples given of the potential amount.
Choices and Options
Lump Sum Vs Regular Payments
Commonly there are three ways funds can be received – as a lump sum, a regular payment/drawdown or a combination of these. Structures such as a ‘line of credit’ (LOC) or a ‘loan offset account’ may be used to facilitate this. There are pros and cons associated with each approach. Before selecting a particular method it may be prudent to seek professional advice. The money obtained and the method used in receiving it may affect other issues – such as Government Income Support payments.
If the regular payment option is chosen this may be provided in various ways. The loan may be set up as a LOC and funds drawn as desired or an authority taken for regular amounts to be automatically credited to a working account. With this option interest does not accrue until the money is withdrawn. Alternatively, the proceeds of the loan may be held in a separate offset account and authority taken for regular payments to a working account. In this case, interest is usually charged on the difference between the loan balance and the offset account balance at the full rate and the offset account balance at a reduced rate – possibly 0.0%.
If taken in full as a lump sum, interest will accrue and be charged on the full balance.
Fixed vs Variable
Fixed interest rate loans mean that the rate charged cannot increase even if interest rates rise. However, if rates fall the reduced rates do not apply to the loan either. Break fees generally apply making it prohibitive to renegotiate the loan. Asking for an example of break fees if rates fell by 3% would be prudent.
A variable interest rate may rise and fall in line with movements announced by the Reserve Bank. The passing on of adjustments in interest rates is at the discretion of the provider.
No Negative Equity
Regulations were introduced in September 2012 which means providers of Reverse Mortgages must offer a No Negative Equity Guarantee (NNEG). Reverse Mortgages offered by some providers prior to September 2012 may have a NNEG. Providers that were not members of the Senior Australian Equity Release Association of Lenders (SEQUAL) offered negative equity products. This means that if the balance of the loan exceeds the proceeds of sale of the property, no claim for this excess will be made against the estate or other beneficiaries of the borrower. It is important the contract be examined thoroughly as this guarantee may be subject to certain conditions that, if breached, could lead to its loss.
Equity Protection Option
Another option providers may offer is to quarantine an amount of equity you wish to keep as a legacy. A fee may apply for this option and will probably reduce the amount you can borrow.
Increasing the Borrowing in the Future
In some cases applicatins who have not needed the total amount they were borrowing at the time but who were contemplating borrowing a larger sum of money to avoid having to apply for a loan increase at a future time.
The main concern with this course of action is if the borrower does not need the extra money but uses the funds anyway, resulting in a much higher debt at the end of the loan. This of course reduces the remaining equity in the property which for some is an important concern.
The benefits in following this course of action is if there is a change in the policy of the lending institution, the loan is already approved. There is also the convenience of not having to apply for the increase at a later time, possibly avoiding extra application fees.
In this situation it would be prudent to calculate the costs that could accrue if additional funds were borrowed initially compared with increasing the amount of the loan at a time when the funds were required. Where the loan amount is to be increased in the future a further application fee usually applies. For example, if $30,000 was borrowed and retained for 2 years, assuming a borrowing interest rate of 8.5% the interest accrued on the unused funds would be about $5,538 (assuming monthly compounding). Assuming the funds were invested at 5% (compounded monthly) and neither tax nor reduction in government income support applied, the cost over 2 years would be $2,390.
This is because of the extra interest accrued on the larger amount borrowed. Provided the application fee remains stable applying for the additional borrowing later may be cheaper.
Other options include having the approval for the higher amount but not drawing the funds until they are required – a LOC. In practice, some people who have this option do not exercise self-control and spend the additional amounts sooner than they intended.
Accommodation Bond Facility
This credit product may provide a solution for retirees to fund Refundable Accommodation Deposits required by aged care facilities by accessing equity in their home. Although similar in structure to a Reverse Mortgage two key differences apply:
The proceeds are to be used to cover the cost of a Refundable Accommodation Deposit and other ongoing aged-care related costs;
They generally have a maximum loan term of five years although the provider may agree to extend the term.
Repayment is required at the end of the term or when the first of the following events occur:
within 180 days after either the death of the borrower or if more than one borrower the death of the last borrower or 180 days after the borrower exiting aged care
the mortgaged property is sold or transferred;
Amounts borrowed can range from $20,000 to $1,000,000. Like a Reverse Mortgage regulated borrowing limits apply. These are also known as the LVR.