I recently received a message from a loyal reader about reverse mortgages and how they have caused some stress within his family.
Andrew (name has been changed) has a grandmother who is almost 90 years old. She lives alone (her husband passed away a few years ago) in a small house that she owns. She has lived in the house for over 40 years and it is fully paid off.
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Her home was in desperate need of some urgent repairs, and her retirement income wasn’t sufficient to cover it. She took out a reverse mortgage to tap into the equity in her home. She borrowed approximately $50,000 as a lump sum to get the repairs completed.
What is a Reverse Mortgage?
Reverse mortgages (often called ‘CHIP’ mortgages – Canadian Home Income Plan) have become a popular tool for retirees looking to tap into the equity they have built up in their homes. They can help pay for any unexpected financial situations like a car repair, medical bills or home repairs (as in this case) without the income qualifications attached to a traditional mortgage.
Rather than being paid off like a traditional mortgage, a reverse mortgage grows over time since there is no set repayment schedule and interest accumulates over time. Most people pay off a reserve mortgage when the home is sold. It usually allows for up to 50% of the homes current value can be given in tax-free cash.
Advantages of a Reverse Mortgage
- The funds are tax-free – it can provide for some much-needed cash in the event of a financial emergency and they can be great for seniors who have low incomes but have a ton of equity in their homes
- Flexibility – the cash can be taken as one lump sum, an annuity (monthly cash payment) or as a line of credit. There are no restrictions on how the cash is used and it is typically used to fund anything from vehicles, home renovations or travelling.
- Any amounts received from a reverse mortgage don’t affect government benefits like Old Age Security (OAS), Canada Pension Plan (CPP) or Guaranteed Income Supplement (GIS)
In Andrew’s case, his grandmother was able to easily tap into her home’s equity to get the repairs done on her home, and the money received was tax-free and had no affect on her retirement income (mainly pension income).
Disadvantages of a Reverse Mortgage
- The rates are typically higher than a traditional mortgage. This can lead to thousands in extra interest paid on the mortgage
- It can slowly ‘chip’ away at the equity in a home over time. There are no set payment schedules which means the interest only grows over time and the principal remains the same.
- There are costs of obtaining the mortgage. Real estate appraisal fees (up to $500), legal fees (approximately $1,000), and other admin costs (approximately $500) can really add up.
In Andrew’s case, his grandmother borrowed $50,000 at 5.50% – which seems quite high compared to current traditional mortgage rates. The appraisal and legal fees were also lumped in with the mortgage.
The problem with her situation is that she hasn’t made any payments on the mortgage and the amount owing is now much higher than the original $50,000 borrowed.
Why They May be a Bad Idea
Reverse mortgages have no set payment schedule, so unless you diligently pay it back over time – the amount of the mortgage can really grow over time. This could lead to a significant drop in equity in the home, as the mortgage usually gets paid out when the home is sold (or if the homeowner passes away).
In the case of my Andrew’s grandmother, she borrowed $50,000 and (without the knowledge of her family) has gone almost 10 years without making any payments.
The amount owing has ballooned to nearly $100,000 – almost double the original amount.
The magic of compound interest has essentially worked against her, and now the amount owing on her home is growing at an increasing rate.
This is an issue that has caused stress for Andrew and his family since the value of his grandmother’s home has remained relatively steady at $325,000. This value, along with the nearly $100,000 owing on the home, has changed the estate planning for the family and caused significant stress since they were not aware the amount owing was so large.
Conclusion: Anyone borrowing money should always have a plan to pay it back, and reverse mortgages are the same. They allow seniors to tap into the equity in their homes and spend it any way they wish without affecting government benefits, but interest rates are higher and there are fees involved. Anyone considering one should always do the math first – as it can be quite alarming and can cause stress in some cases.
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