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Reverse mortgages need a rethink if they’re the new age pension

Reverse mortgages can be risky for both borrowers and lenders. Flickr/American Advisors Group, CC BY-SA

The Commission of Audit has recommended including homes above a certain value in the means test that determines who gets the age pension and how much. Under the proposal, homes valued in excess of A$500,000 would be assessable for singles, while for couples the trigger would be A$750,000.

The family home is currently exempt from the assets test but the commission argues this is inequitable because it means high levels of wealth are sheltered. It suggests a more comprehensive means testing regime be put in place by 2027-28.

If this proposal is picked up by the federal government, it would see a sizable group of retirees required to call on the equity in their homes to help fund their retirement.

It would be a brave government that “forced” pensioners to sell their homes to release that equity, which makes reverse mortgages a likely tool for retirees who need to convert their home into cash flow.

Even now, a reverse mortgage can be an alternative to “downsizing” into a smaller and cheaper home to release funds for retirement.

How reverse mortgages work

A reverse mortgage allows homeowners to access a loan, or a regular stream of cash (an annuity), using their home as collateral. Borrowers continue to live in the property until death – or they move into aged care – after which the loan is repaid from the sale of the house.

The mortgage can apply to the full value of a property, or borrowers may be able to access “residual value protection”, allowing them to set aside a portion of the house’s value to be available for aged care or as an inheritance.

Interest rates are generally higher than for standard home loan products due to less competition in this sector and higher risks for the lender.

For some years now, on the back of the lessons learnt from the global financial crisis, there have been government-imposed rules around “negative equity” that prevent lenders from extracting repayments beyond the value of the house. This means lenders can suffer a loss if the loan amount exceeds the value of the house at the date of the sale, something that may happen in a softening property market.

Reverse mortgages involve compounding interest, where interest charges are added onto the loan as they accrue. This means the loan amount can rise quickly.

Taking out a reverse mortgage can affect the availability of funds for major items such as aged care and bequests, and it can have an impact on other family members who may live in the house. Ultimately reverse mortgages demand a much higher degree of financial literacy from individuals, who may need professional advice on issues such as tax and Centrelink implications.

Could we end up like the US?

Despite the fact that reverse mortgages helped send mortgage insurer the Federal Housing Administration bankrupt in the US, the market there is returning.

How would increased demand for reverse mortgages change the Australian financial system?

The bulge of baby boomers entering retirement, along with a change to means testing along the lines proposed, could be expected to lead to an increase demand in such products. In theory, new lenders would be attracted into the market, thus increasing competition and driving interest rates down (in relative terms, against the risk-free rate).

Three main sources of risk are apparent, the first of which is declining real estate values, or the risk of negative equity. The loan amount may end up being larger than expected if the borrower enjoys a long life or property values fall.

Second, with a reverse mortgage the lender generally has no recourse to assets other than the home. Third, at this stage of life borrowers may neglect maintenance and property improvements, eroding the value of the home.

Many of these risks, in particular real estate values and an ageing population, are systematic and may become systemic. Should reverse mortgages enjoy significant growth, as projected, Australian lenders would have increased exposure to house price risk. If house prices dropped, more defaults would occur.

The impact of growth in reverse mortgages on the housing market itself may be limited, as properties are sold only after death or upon a move into aged care. But there may be a decrease in downsizing activity if these products become more popular.

An alternative to bank lending

Currently, reverse mortgages are mainly provided by the banking sector, which is already over-exposed to mortgages. At the same time, the superannuation sector is looking for long-term investment opportunities. Why not create financial products where super funds provide cash flow for retirees in exchange for access to the value in their homes?

Some super fund members may not want further exposure to Australian real estate, particularly if they are already house owners, but this could be an additional option in the current portfolio of investment choices offered by funds to their members.

The outcome might be comparable to the situation in overseas pension systems – such as Germany’s – where pensions are organised to a large degree as intergenerational wealth transfers, where one generation pays for the next generation.

Such a system could increase the resilience and efficiency of the Australian financial system.

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