What is a reverse mortgage and how does it work?

Reverse mortgages allow people to borrow against the equity in their home. They are usually targeted at seniors, who often use the released equity to pay for things such as lifestyle or medical expenses, renovations or even to help their children enter the property market.

But it’s important to read the fine print before entering into a reverse mortgage to ensure the arrangement is fair to the home owner. This is because in 2018, the Australian Securities and Investments Commission reviewed reverse-mortgage lending and found borrowers had a poor understanding of the risks and costs of reverse mortgages and how they could affect their ability to afford their lifestyle needs.

How reverse mortgages work

Let’s say Mary, 60, owns her home worth $600,000 outright. Mary wants to use her home as security to release $10,000 in a reverse mortgage to fund a holiday. She doesn’t have to sell the property to release this money and continues to live in it.

Mary does not have to make repayments after taking out a reverse mortgage, with the funds paid off in full when she sells the home, goes into aged care or dies, whereby the estate pays it off. But, interest is payable on the $10,000 equity release.

Reverse mortgages may be an alternative if other finance options cannot be realised due to the property owner’s income situation.

“They may be suitable if you’re capital-rich but income-poor and don’t want to downsize your home by selling it and buying a cheaper home to have extra money to spend,” says Gianna Thomson, a principal financial planner with financial advice firm Thomson Wealth. “The older you are, the more you can borrow against your home, so retirees often use reverse mortgages,” she says.

At 60, you can usually borrow between 15 and 20 per cent of your equity, and you can generally borrow 1 per cent more for every year over 60. At 70, you could borrow as much as 25 to 30 per cent of the equity in the property.

Scott Kuru, founder of property education group Freedom Property Investors, explains property owners may either draw against their equity in lump sums, receive regular pay outs or access a credit line, but this will eat away at the equity.

“The reverse mortgage provider cannot claim more against the home than was agreed as part of the arrangement,” he says. “Let’s say you draw down equity to renovate the home, effectively increasing its value and, with it, the equity. The amount borrowed through the reverse mortgage will be based on the amount, not the value of the property.”

Don’t forget to read the fine print

It’s important to be aware of potential downsides of reverse mortgages. For instance, the equity release compounds with interest and interest rates for reverse mortgages can be higher than the rate payable on a standard mortgage. This can really add up over time, particularly for unsuspecting retirees who don’t understand what a reverse mortgage is.

It’s also important to consider your spouse, if you have one, if you are taking out a reverse mortgage. “If a couple lives in the home but only one person owns the house, if there is a reverse mortgage attached to it, the surviving spouse might not be able to live in the home after the owner’s death, particularly if the house needs to be sold to repay the loan,” Thomson says.

James Ballantyne, principal of Ballantyne Law Group says reverse mortgages can be complex. “They carry a degree of legal and financial risk,” he says.

As a result, Ballantyne says reverse mortgages will only suit people who have a clear understanding of the risks involved. He says it’s important to get independent financial and legal advice before taking out this type of loan.

“Advisers need to get a clear picture of the borrower’s circumstances, including the purposes for the loan,” he says. “If the borrower’s health and lifestyle costs are reasonable, we are less likely to recommend this arrangement. Reverse mortgages are not appropriate for people who do not understand the legal and financial implications, which includes vulnerable people and people who lack capacity.”

Making the most of it

If you are taking out a reserve mortgage, it’s a good idea to estimate the long-term costs, including set-up fees and compound interest.

“It’s also an idea to review any estate plans, particularly if the home was intended to be inherited by a particular person,” Thomson says.

Reverse mortgages can be appropriate in some circumstances. But, it’s essential to understand what you are getting into before going down this path.