With their retirement plans thrown into disarray by market turmoil, some people are considering whether they should unlock the equity in their homes to rebuild their position.The money tied up in property could well be the key to ensuring that there’s a little bit of shine to their golden years.
But the process of unlocking equity is a complex one that has to be thought through carefully.
It involves considering not just your desired lifestyle in retirement but also current and future property prices and what you plan to leave to your beneficiaries.
At the peak of the property boom there was a raft of products allowing people to convert their hard-earned home equity into cash.
If you were still at work you could tap into your home equity for renovations or other spending, while reverse mortgages were aimed at the retirement market.
But the global financial crisis changed the lending landscape dramatically. Now more risk averse, banks reverted to more traditional forms of lending with tighter criteria.
Financial products researcher Canstar says that at one point 14 institutions were offering 55 reverse mortgage products. That has since contracted to eight institutions and 11 products, plus one accommodation bond loan.
The wind has also been taken out of the sails of the equity release sector by the grave uncertainty about where property prices are headed.
Nevertheless, demand remains. The communications manager with the National Information Centre on Retirement Investments, Craig Hall, says there has been a surge in the number of people asking about unlocking equity.
Federal government statistics say 42,000 people currently have a reverse mortgage. That figure increases by 5000 a year.
As the name suggests, reverse mortgages work in the opposite way to regular mortgages.
In the traditional mortgage – the sort you used to buy your property in the first place – the amount of interest you paid as part of your fortnightly or monthly repayments would have declined over time.
That’s because the interest on a principal and interest loan is charged on the outstanding capital. As the loan balance falls over time, so does the amount of interest you’re charged – as long as rates don’t rise.
With reverse mortgages, the interest compounds into the loan instead. Instead of the loan reducing over time, it increases as interest is added to the starting loan.
In theory, the size of the loan could eventually grow to be more than the equity you have in your home. However, recent legislation means you can no longer end up owing more than the value of your home.
Canstar research manager Chris Groth says what usually happens is that you receive a lump sum representing at least a portion of the equity in your home.
“The lenders involved tend to be strict with their loan to valuation ratios (LVRs) with these products. So if your house is worth $400,000 you may find the LVR is 25 per cent, so you may well find the most you will get is $100,000.’’
That may seem a tidy sum but Groth poses the question: “If you live to 95, will it be enough? It may not be the answer for your retirement,’’ he says.
With property prices flat or even in decline in many parts of the country in the past few years, there’s no guarantee your home will be worth more in the future, which means you – or your children – could be left with nothing at the end of a reverse mortgage.
If you borrow $100,000 and you’re being charged a compounding 8 per cent interest, with no repayments being made, in about 20 years’ time the $400,000 value of the house in our example may have been eaten up.
Hall says that’s why professional advice is crucial.
“You need legal and financial advice. You should be speaking to a financial planner as maybe there’s another way to unlock the value in your property, such as by downsizing your home,’’ he says.
Still, NICRI sees some merits in reverse mortgages. Financial information officer Basil La Brooy says reverse mortgages can provide income for people who have worked hard during their lives.
“They can mean people can get to enjoy their retirement more than they would otherwise,’’ he says.
Many people worry about tapping into the equity in their homes because that will eat away at the kids’ inheritance, La Brooy says.
Legacy and lifestyle
“There is, of course, the issue of the legacy which may be left to your children, which may be reduced. But there’s also a very important question about the lifestyle you can have during your retirement,” he says.
“Under the right circumstances, and with the right product, unlocking equity can be a good strategy.’’
Legislation means that no one taking out a reverse mortgage can end up owing more than their home is worth.
This is known as the “no negative equity” guarantee.
It is theoretically possible for compounding interest to lift the debt beyond the market value of a property, so a borrower could end up still owing the bank or financial institution even after the sale of a property. However, the federal government announced at the last election that it intended to limit the downside for users of reverse mortgages and this became part of its consumer credit legislation.
Financial Services Minister Bill Shorten says the changes will protect people who borrow money, especially if they are in a vulnerable position due to age or health.
It was previously hard for consumers to tell when their reverse mortgage had gone into negative equity.
The new law is designed so people will not be forced to sell their home or other assets to repay the debt.
However, there are exceptions to the market value rule, such as if the borrower deliberately causes damage to reduce the value of the property.
Other changes include enhanced disclosure requirements, including taking steps to show potential borrowers the effect of the proposed reverse mortgage over time.
There are also changes to the conditions under which a borrower can be deemed to be in default. Previously, a borrower could have been in default if they didn’t pay their council rates or credit card.
The new legislation also focuses on what happens to people who are left behind when the title holder dies.
Some reverse mortgage contracts allow other residents to remain in the property while others don’t.
If a proposed reverse mortgage contract doesn’t include “residency protection” provisions, the borrower must be told of this before the contract is signed.