Reverse mortgages: How they work

Ahhh, the Golden Years. When everything you’ve worked so hard for over the last 30 to 40 years comes to light. We all like to envision ourselves in some cozy cabin, on the golf course or traveling the world, all while being comfortably retired.

Comfortably retired, for most people, means financially. Sometimes, however, you may need some extra retirement income. If you own a home, something you might want to consider is a reverse mortgage.

Reverse mortgages have been available in the United States and United Kingdom for some time now. It was only in 1986 that chartered accountant William Turner founded the Canadian Home Income Plan – CHIP.

Wendy Dryden, vice-president of marketing and customer service, says there was an obvious need to offer this kind of product in Canada.

“We had an equivalent need, but didn’t have an equivalent product available.”

Age requirement
You’ve probably heard of reverse mortgages. Basically, you get a lump-sum payment based on the equity you have in your property. But there is actually quite a bit more to it than you may realize.

The reverse mortgage CHIP offers is available under certainircumstances.  Age is one of them. You must be 62 or over. If you own your property with a spouse, both of you must be 62 or over.

CHIP came up with the age requirement based on actuarial science tables. Payouts range from ten to 40 per cent, based on age, sex and life expectancy. 

Repayment terms
Repayment of the loan isn’t required until you sell your home, or it will be taken care of with your estate should you pass away before you sell your house.

You don’t have to pay any interest until repayment of the loan.

Interest accrues on a semi-annual basis. Obviously, if you have a reverse mortgage for a long period of time, the interest charges will be quite high when you go to payout the mortgage. But, there are ways you can prevent having to pay a large amount of interest all at once.

Interest payments
One option is to pay the interest charges annually. You’re not required to do this, but certainly can do so if you choose. That way, the only amount you’ll owe in the end is the principal.

Reverse mortgages are very flexible when it comes to interest payments. You can pay one year, then skip the next, or whatever works best for you on a year-to-year basis.

Dryden says reverse mortgage approval is based on limited information. You will need to provide only five things. Name, address, age and spouse’s age if applicable, a brief description of the property and whether or not you have any outstanding loans secured against the property.

Property appraised
Based on the above criteria, CHIP can provide an initial estimate of the amount you qualify for. If you decide to proceed, the homeowner must pay for an independent appraisal of the property. CHIP then offers a final quote.

There is only one limitation when it comes to what you can do with the money. If there’s a conventional mortgage or home equity line-of-credit on the property, proceeds from the reverse mortgage must first pay off those debts.

Spending decisions
The rest is yours to spend as you see fit. However, CHIP is trying to let seniors know that there are certain advantages that should be considered before making any spending decisions.

“Traditionally, our focus has been on communicating that a reverse mortgage is a source of incremental retirement income,” says Dryden. “But not all retiring Canadians will need that, and there are other advantages to consider.”

One of the biggest advantages is generating tax-sheltered income.

Tax considerations
Gordon Pape is one of Canada’s best-known financial commentators. He’s representing CHIP to help communicate information about reverse mortgages to Canadians. He says reverse mortgage money has several tax advantages if used properly.

Pape says the interest that accrues on a reverse mortgage becomes tax deductible if the loan is used to invest.

“My advice is that people don’t use the money for speculative purposes, such as the stock market. Use the money conservatively to generate tax-sheltered income.”

Pape says investing in bonds, preferred shares or other conservative types of securities can do that.

“If you invest in something that pays dividends, you’ll get the benefit of the dividend tax credit plus the deductibility of the mortgage interest,” he says.

Market value
Sounds like wise advice. Many people, however, like to use the money for material purchases. And that, says Pape, is just fine.

“Maybe you’ll take out a reverse mortgage on your home to buy retirement property somewhere. You could take that money and buy your condo or RV or whatever you want, and not have to make mortgage payments to anybody.”

Another attractive benefit of a reverse mortgage is that the home itself is the maximum indebtedness. In other words, should the amount owing exceed the market value of the home, there’s no other charge against the estate. The reverse mortgage total cannot exceed the fair market value of the home.

Once the house is sold, the mortgage is due. But that doesn’t mean a sale is necessarily required, says Pape.

“The house doesn’t have to be sold. If the last surviving spouse dies and one of the kids takes over the family home, they could take out a conventional mortgage to repay the reverse mortgage.”

Other options
With the availability of home equity lines-of-credit, one might wonder why to even bother with a reverse mortgage. There are three main differences between HELOC’s and reverse mortgages that you’ll want to consider.

• First of all, HELOC’s require regular repayment.
• Secondly, the lender often requires a minimum income level.

“In the case of a reverse mortgage,” says Dryden, “we don’t even ask you how much money you have as your annual income. That’s because we don’t expect you to make regular payments.”

• Another difference to consider is that with a reverse mortgage, you’ll never be forced to sell your property, says Dryden.

“With a line-of-credit or conventional mortgage, you might be asked to sell your home to be able to settle the debt. With a reverse mortgage you’ll never be asked to do that because it’s a life-term loan. Until you decide to sell, you’re not required to repay us.”

Not for everyone
Reverse mortgages aren’t for everybody, says Dryden. She says you should avoid them if you’re planning to sell your house within three years. If you do that, and therefore have to repay a reverse mortgage, you’ll end up paying a penalty similar to that of conventional mortgage early payouts.

And there’s something else you should do before signing up, adds Pape.

Discuss beforehand
“If you’re going to do this, you should have a financial advisor who is knowledgeable and who understands what your goals are.

You should also have your own independent tax advice, and also talk this over with your kids.

“Don’t do something like this without other family members being aware of it, especially if it could affect them down the road.”

Dryden agrees. “This isn’t a case of too good to be true. This is a loan, and eventually it needs to be repaid.”

CHIP is the Canadian Home Income Plan. Several financial institutions also offer reverse mortgages, including Royal Bank Financial Group, The Bank of Montreal and ScotiaBank.

-Reprinted with permission from Business in Calgary Magazine, November 2001.