When the ‘last resort’ isn’t

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  By Guest Blogger Sinan Terzioglu

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According to data from the Office of the Superintendent of Financial Institutions (OSFI), reverse mortgages in Canada continue to grow at a rapid rate. As of June 2024, outstanding reverse mortgage debt surpassed $8.2 billion, marking an 18.3% increase from the previous year and a 39.3% increase over two years. This trend is concerning, as reverse mortgages should only be considered as a last-resort, short-term solution rather than a long-term retirement strategy.

A reverse mortgage allows homeowners to borrow against their home equity while they continue to live in the property. The funds are received tax-free, either as a lump sum or as regular monthly payments, and unlike conventional mortgages and HELOCs, no income is required to qualify. Reverse mortgages are particularly appealing for those with significant home equity who wish to stay in their home but lack sufficient cash flow to cover their expenses.

To qualify for a reverse mortgage in Canada, homeowners must be at least 55 years old and reside in the home for a minimum of six months each year. If eligible, they can initially borrow up to 55% of the property’s value. Repayments are not required until the mortgage is due, which happens when the homeowner sells the home, moves out, or the last surviving owner passes away.

Initially, it seems too good to be true and it is. For instance, reverse mortgages come with high setup costs, and the interest rates are typically significantly higher that those of conventional mortgages. Also, if interest payments are not made, the total debt increases at an accelerating rate due to interest being charged on the accumulated interest, which significantly diminishes home equity over time.

Example – Karen, a 65-year-old widow and resident of Ontario, retired five years ago. She has been living in her paid off home valued at $1 million for over 25 years and wishes to stay there for the rest of her life. Without a pension, she relies on $1,400 per month from CPP and OAS. With no other income and her liquid assets exhausted, she is contemplating the following options to cover her monthly expenses of $5,500:

Option 1 – Choose a 7% fixed rate reverse mortgage with no initial lump sum, receiving a monthly loan advance of $4,000.

This option is attractive to Karen because it allows her to stay in her home, and the monthly loan advances, combined with her CPP and OAS benefits, would cover her expenses. Assuming her home appreciates by 2% annually, its value would be around $1.1 million after 5 years. However, her total interest and balance owing at the end of the 5-year term would amount to $288,042, with no guarantee she can renew the reverse mortgage for another 5-year term and continue to receive $4,000 per month. Even if she could utilize the strategy for 10 years, the compounding interest would significantly erode her home equity over time, highlighting why reverse mortgages are not ideal for the long term.

After 10 years, if Karen doesn’t make any interest payments, the accumulated interest would amount to $216,377, bringing her total debt to nearly $700,000. If she sells her home for $1.2 million and invests the remaining equity, her assets would fall short of covering her expenses for another 20+ years especially if she requires assisted living, leaving her at high risk of running out of money in her later years.

Option 2 – Choose a 7% fixed rate reverse mortgage with a $100,000 lump sum advance and a $3,000 monthly loan advance. The $100,000 lump sum would be used to renovate her basement, which she anticipates she can rent out for $1,500 per month.

This option would enable Karen to stay in her home, with monthly advances reduced by 25%. Combined with her rental income and government benefits, this would cover her expenses and taxes owed on the rental income. However, managing rental property in Ontario can be challenging, particularly at Karen’s stage of life. After 5 years, her total interest would amount to nearly $78,000, and her balance owing would total $357,794, leaving her no better off financially.

Option 3 – Sell her home for $1,000,000, invest the proceeds in a balanced and globally diversified portfolio earning an average annual return of 6%, and rent a home.

This approach would allow Karen to comfortably withdraw $4,000 per month without straining her portfolio over the balance of her life. Combined with her government benefits, she could sustain a lifestyle costing $5,500 per month while maintaining her net worth. If Karen requires assisted living in the future, she will have the necessary liquidity to support herself, significantly reducing the risk of depleting her assets in her later years.

In summary, relying on a reverse mortgage for long-term cash flow is a very high-risk strategy for most people due to the compounding interest, which can cause the debt to grow significantly. Although a home’s value is likely to appreciate over time, it will probably do so at a much slower rate than the accumulating debt. For those with 20-30+ years of retirement to fund and limited liquid financial assets, a reverse mortgage would likely erode most, if not all, of the home equity within 10-15 years, well before death. Therefore, a reverse mortgage should be considered only as a last-resort, short-term solution.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.

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About the picture: “Thanks for the blog post and responding to this, Garth!” writes ‘D’ who was savaged by the cruel steerage section two days ago. “Very much appreciated! I guess the one factor that isn’t brought up, is the stability that comes with home ownership. I grew up with renting parents and have seen my mom get evicted (at no fault of her own), from 5 places. Food for thought when it comes to decision making. But alas, here is a picture of my beautiful, slightly anxious but getting better, rescue dog. Her name is Peanut. A gem of gems.”

To be in touch or send a picture of your beast, email to ‘garth@garth.ca’.

Source: https://www.greaterfool.ca/2024/10/11/when-the-last-resort-isnt/