Not long ago borrowing against your home to meet basic living expenses was unthinkable for most retirees.
Times have changed.
With equity markets slumping, bond yields in the doldrums and longer life expectancy, the first wave of Baby Boomers is finding itself short on cash and long on life — and that's why they're turning to reverse mortgages.
Establishing a reverse mortgage to meet those needs hits home — literally. The family residence is often the inheritance parents hope to pass along to their children, but financially it could be the only practical alternative.
A home is the biggest investment for most Canadians and, depending on its location and other circumstances, it may be the most lucrative. The Canada Mortgage and Housing Corporation estimates the average Canadian home appreciates in value each year by an average 5.4 per cent over a forty-year period — and, while short-term home values will rise and fall — they believe the long-term trend will continue.
What is a reverse mortgage?
A reverse mortgage allows property owners to tap into their home equity in a safe, tax-efficient manner. The homeowner receives payments from a lender using the property as collateral. It's reverse because the bank pays you, and not the other way around.
Plan members also retain legal ownership and can remain in their homes as long as they wish.
The full amount, plus interest comes due when the home is sold by the owners or as part of their estate when they pass away.
It's tax-free because the sale of a principle residence is not taxed.
Like traditional mortgages, the borrower assumes the risk of higher borrowing rates in the future. Plan members can choose to make regular payments on the interest or add them to the total amount owing.
Also, like a tradition mortgage, reverse mortgage customers are exposed to the double-risk of rising mortgage rates and falling property values.
The Canadian Home Income Plan, or CHIP, is the dominant player in the Canadian reverse mortgage market. CHIP allows homeowners 55 years or older to borrow up to fifty per cent of the current appraised value of their homes. Plan members can borrow in lump sums or regular advances over time.
CHIP's borrowing rates are structured much like a traditional mortgage — fixed or variable for different periods of time - but are generally higher. Unlike traditional mortgages total interest payments grow and compound as the reverse mortgage grows along with the total amount borrowed. CHIP guarantees that the amount owed will never exceed the appraised value of the home.
CHIP makes a lot of its money on fees - set up costs, appraisal fees, legal fees, administrative costs and penalties for leaving the plan early.
Home equity line a better alternative?
However, there is a cheaper way to borrow against your home through a secured line of credit, also known as a home-equity line of credit. Home equity loans made headlines recently following a federal government crackdown on the total amount that can be borrowed against the equity in a home from 85 per cent to 80 per cent.
Considering the dual risks of higher interest rates and lower house prices even 80 per cent is a dangerous amount to borrow against your home, and that's why a home equity loan requires financial discipline.
Unlike a reverse mortgage, which is only required to be paid off when the house is sold, the amount owing on a home equity loan is callable at any time by the lender in some cases. In other words, the bank can technically demand repayment in full any time, forcing the homeowner to sell.
To establish a home-equity line of credit the home owner must pay legal and appraisal fees but the borrowing rate is often half to one per cent above the bank's prime rate depending on the lending institution. Unlike a reverse mortgage the borrower must pay at least the interest owing on a home equity loan — but you can get around that by borrowing the payment on your line of credit.
Borrowing against your home in any manner is not for everyone and is not the only option for homeowners who are tight for cash. Homeowners who wish to remain homeowners can simply downsize to a cheaper home and live off the difference.
Many retirees choose to sell their homes and rent. All that cash can be invested in a more diverse portfolio of securities and decrease the individual's reliance on the value of a single asset.