Repayment deferred: some clarity on reverse mortgages

The pros and cons of accumulating deferred debt on your home

Does a reverse mortgage allow you to unlock a hidden treasure without having to wrestle a map from an unwilling pirate? With all due respect to a good metaphor, the treasure in this case is your principal residence, and the map is the reverse mortgage. The challenge is that the map is fraught with twists and turns that for the financially illiterate can lead to a minefield of adversity.

Not surprisingly, several clients of Croft Financial Group have asked us to weigh in on the benefits and pitfalls of reverse mortgages. And make no mistake, there are significant pros and cons. Depending on the individual circumstances, a reverse mortgage can be the financial equivalent of a free lunch or the foundation underpinning an existential threat to one’s estate plan.

As portfolio managers, we are guided by fiduciary standards that require us to always act in the best interest of our clients. This gives us a unique perspective to pull back the covers and set out the realities – good and bad – that dot the reverse mortgage landscape.

Benefits and pitfalls

Simply stated, a reverse mortgage is a financial product designed to allow homeowners aged 62 or older to access the equity in their homes without having to sell or move out.

While this type of loan can offer several advantages, it also comes with significant drawbacks that potential borrowers need to carefully consider.

The pros of reverse mortgages

1. Access to extra cash

This is the primary benefit of the reverse mortgage because it allows a homeowner the ability to access the equity in a home without selling it. Marketing literature typically highlights attractive benefits such as the following: homeowners can call up much-needed funds to manage financial circumstances such as living expenses, medical bills, not to mention a host of unexpected expenses. The loan is repaid only when the homeowner sells the house, moves out, or passes away, allowing seniors to continue living in their homes while enjoying additional financial security.

2. No monthly mortgage payments

Unlike traditional mortgages, a reverse mortgage does not require monthly payments. The loan is repaid when the homeowner moves, sells the house, or dies. This feature can be particularly appealing for retirees who are struggling to meet monthly financial obligations on a fixed income. Without the monthly expense of mortgage payments, the homeowner can free up cash that can be used for other essential expenses or to enjoy retirement without the worry of mortgage debt.

3. Non-recourse loan

Assuming one can get a non-recourse reverse mortgage, the homeowner or their heirs will never owe more than the value of the home when the loan is due. This is especially beneficial in case the housing market declines, and the value of the principal residence declines. Even if the home is worth less than the loan balance at the time of repayment, the lender cannot come after the homeowner’s other assets to make up the difference. However, in Canada, the most common reverse mortgage is the recourse loan, where the borrower is responsible for any shortfall in the repayment of the loan.

4. Homeownership retained

With a reverse mortgage, the homeowner continues to own the home, maintaining control over their property. This means they can live in the home for as long as they wish. Assuming, of course, the homeowners meet certain requirements, such as maintaining the home and paying property taxes and insurance.

5. Tax-free loan proceeds

The money received from a reverse mortgage is generally not considered taxable income, which can be a significant benefit to those who need to supplement their retirement income.

The cons of reverse mortgages

1. Accumulating loan balance

While the absence of monthly payments may seem attractive, the loan balance on a reverse mortgage grows as time passes due to the added interest and fees. The longer the homeowner stays in the home, the larger the debt becomes. This can create a situation where the equity in the home is gradually eroded, potentially leaving little for the homeowner’s heirs after the property is sold to repay the loan.

2. Costly fees

Reverse mortgages come with a variety of fees, including origination fees, closing costs, insurance premiums, and servicing fees. The total set-up costs can be significant, especially when compared with a traditional mortgage. Some fees are paid upfront, while others may be rolled into the loan balance. These expenses can further reduce the amount of equity in the home, leaving less for the homeowner or their heirs.

3. Impact on heirs

A reverse mortgage can complicate inheritance plans. Since the loan is repaid when the homeowner sells the home, moves, or dies, the heirs may be required to sell the home to repay the loan. In some cases, the home may not be worth enough to cover the loan balance, leaving the heirs with nothing or forcing them, in the case of a recourse loan having to pay off the remaining debt. Additionally, heirs will not inherit the property until the loan is fully satisfied.

4. Eligibility requirements

Not everyone can qualify for a reverse mortgage. In addition to the age requirement of being 62 or older (age restrictions vary depending on the company offering the reverse mortgage), homeowners must also have significant equity in their home and be able to demonstrate the ability to cover property taxes, insurance, and maintenance costs. Also of note, reverse mortgages are available only on primary residences, so second homes or investment properties are not eligible.

5. Potential for foreclosure

While reverse mortgages are designed to be flexible, homeowners must continue to meet certain obligations, such as paying property taxes, property insurance, and must maintain the property. If the homeowner fails to meet these obligations, the lender can initiate foreclosure procedures. This can be a concern for seniors who may not be able to manage these responsibilities, potentially jeopardizing their ability to remain in the home.

6. Complexity and misunderstanding

Reverse mortgages can be difficult to fully understand, especially for seniors who may not be financially savvy. The terms, fees, and long-term consequences can be overwhelming, and many homeowners may not realize the full impact of the loan until later. In some cases, individuals may take out a reverse mortgage without fully understanding the costs or the effect it will have on their financial situation in the long term.

Summary

In our view, a reverse mortgage can be an effective tool for certain seniors looking to access the equity in their homes and supplement their retirement income. The ability to live in the home without monthly mortgage payments while gaining access to tax-free funds can provide financial relief. However, the costs, accumulating debt, potential impact on heirs, and eligibility requirements mean that a reverse mortgage is not suitable for everyone. As always discuss the pros and cons of a reverse mortgage, and its potential impact on your financial security and estate, with an independent financial adviser (i.e., one not connected to the mortgage business) before signing on the dotted line.

Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.

Disclaimers

Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

R N Croft Financial Group Inc. is a Licensed Discretionary Portfolio Management and Investment Fund Management company serving investors and investment professionals across Canada since 1993.

Image: iStock.com/Marcus Millo

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