Living High Off The Children's Inheritance

Sydney Morning Herald

Saturday September 13, 2003

ANNETTE SAMPSON

Asset rich, cash poor. It's a problem facing an increasing number of older Australians.

The booming property market has left many retirees sitting on a valuable chunk of real estate.

But short of selling up, they have no way of using this wealth to improve their retirement lifestyle.

However, the entry this week by the Commonwealth Bank into the so-called reverse mortgage market has signalled that big business finally sees this as an area where it can make a buck.

Reverse mortgages are often known in the US as ``rising debt, falling equity" loans which pretty much sums up what borrowers are in for.

With a traditional home loan you borrow a set sum and make regular repayments that cover your interest and gradually pay off the principal.

The progress is slow at first, but as you pay off your balance, the interest charged falls and your repayments start to make a real difference to the loan balance.

A reverse mortgage turns that upside down.

You borrow a set amount, but you don't need to make any repayments. Instead the interest is added to your outstanding loan balance.

Because you are then paying interest on a bigger amount, the size of your loan increases the longer you have it.

Reverse mortgages are quite common overseas, though few products have been available in Australia.

In June, the US National Reverse Mortgage Lenders Association reported new reverse mortgage loans had reached record levels with more than 1800 signed up in that month alone.

The association attributed their popularity boost to the fact that many retirees' incomes have fallen thanks to a combination of low interest rates and shoddy returns on share-based investments.

By taking out a reverse mortgage, they can maintain their lifestyle without moving out of their home.

In Australia, reverse mortgages have been slow to take off.

Advance Bank offered a Money for Living product in the 1990s which was withdrawn, though Advance's new owner, St George Bank, came back into the market in December with its Seniors Access Loan.

While the response to this product has been stronger than expected, St George has been low key in promoting it.

Customers who have used the loan have typically been self-funded retirees, though they have used the money for everything from medical expenses to investments to holidays.

But while these loans can undoubtedly prove useful, they are not something to enter into with your eyes closed.

The graph shows what would happen to a borrower who took out a $120,000 loan against his $600,000 property at age 65.

This is the maximum loan to valuation of 20 per cent allowed by the Commonwealth for borrowers aged 65 to 70 (St George allows a maximum loan at this age of 15 per cent but has an overall loan limit of $100,000 and under-70s are limited to $80,000).

The graph assumes the borrower pays the current interest rate of 7.57 per cent and the $950 establishment fee charged by the Commonwealth, though it doesn't include that bank's $12 monthly fee.

By year 7, the borrower's outstanding loan balance would have grown to more than $200,000 and it would take around nine years for the loan balance to double.

If this borrower lived to his life expectancy of 81, his estate would be liable for a loan of around $415,000.

His beneficiaries could either pay out the loan and keep the house, or it could be sold.

However, don't forget that the house should hopefully have risen in value in this time as well. For the graph, we have conservatively assumed that the home increased in value by only 2 per cent a year during this period.

At the borrower's life expectancy, it would be worth more than $800,000 and the borrower's equity in it would be a bit less than half.

After 30 years, if the loan remained unchanged, the loan would be worth more than the borrower's home.

Most of the US loans, and the St George and Commonwealth products, are non-recourse loans which means that, if the worst happens and the loan exceeds the value of the home, the bank can't ask you or your estate to make up the difference.

That along with the fact that the bank isn't actually getting any cash from you for the life of the loan is the reason generally cited for the higher interest rate.

Obviously, the closer the rate of home growth is to the interest charged, the better your position.

In the case we've just looked at, for example, if the home's value had grown by 5 per cent a year, the borrower would still have almost $1.5 million worth of equity in the property if he lived to 95, though the loan to valuation ratio would still be higher than the original 20 per cent.

Commonwealth says it will require all customers to sign a document stating they've sought independent advice on whether its reverse mortgage loan is suitable for them. St George requires borrowers to get written legal and financial advice.

These, and the relatively small amounts of money that can be borrowed, are a good first step in ensuring older Australians understand the effects of what is a complex financial product.

But if a swag of lenders jump on the bandwagon, and softly softly marketing becomes hard sell, further protections may be needed.

The bottom line is that any product that allows interest to be capitalised costs a lot over the longer term.

Borrowers need to be made aware of this, or there will be a case for the regulators to get involved.

Points to ponder

* What is the maximum that can be borrowed? Because interest is capitalised, the loan-to-valuation ratio (LVR) will grow unless your home's value grows at a faster rate than the interest costs. The higher the initial LVR, the greater the chance that you will end up with lower levels of equity later.

* How long will the loan run for? The effects of paying interest on interest accelerate as time goes on. That's why both the Commonwealth Bank and St George Bank lend less to younger retirees than they will to older ones.

* What's the likely longer-term rate of growth on my home (not just what's happened in the past couple of boom years)?

* What are the costs? Commonwealth, for example, requires a new valuation (at the borrower's expense) every two years.

* Under what circumstances can the bank demand I repay the loan?

* Is the loan a non-recourse one?

* Is my family OK with this?