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Reverse Mortgages

Although a reverse mortgage does not have to repaid until the owners die, move or sell the property, they contain a number of complexities and are not appropriate for everyone. We shall review the following aspects of reverse mortgages:

• mechanics of a reverse mortgage
• the downside of these loans
• payment options
• tax implications
• a checklist of reverse mortgage considerations

Mechanics of Reverse Mortgages

The exact amount of the loan is dependent upon the age of the homeowners and current interest rates. After a reverse mortgage has been obtained, individuals will still own their home and the only restrictions placed on homeowners is to maintain the property, taxes must be kept current and ensure there is an adequate level of insurance coverage. This should not be a burden as homeowners would normally perform these tasks with or without a reverse mortgage.

Downside of Reverse Mortgages

There are three potential disadvantages of a reverse mortgage:

1) a reduction in the equity of the home once it sold to repay the outstanding loan.
2) fees and expense related to the mortgage.
3) It can significantly reduce the potential inheritance for beneficiaries

Although a reverse mortgage provides seniors with an important source of cash, the family is trading a significant portion of the equity in their house for a loan plus interest that will continue to compound while they live in the home. This has two potential implications:

• a smaller estate will be left to their children or other beneficiaries. Depending upon the family dynamics, it may be appropriate to discuss the concept of a reverse mortgage with the potential beneficiaries prior to obtaining the loan

• if the individuals can no longer live in the home for health, financial, or other reasons, the remaining equity may be inadequate to fund their future needs. This could be especially critical if a spouse has to spend a significant amount of time in an old age home or retirement community once they move out of their principal residence

Although reverse mortgages reduce the equity for potential beneficiaries of the family home, it seldom eliminates 100% of the owner’s equity. According to officials at the Canadian Home Income Plan:

• 99% of participants have equity remaining in the home after it is sold to repay the loan

• on average, over 50% of the value of the home remains after the home is sold

Repayment Options

Upon the receipts of funds from a reverse mortgage, homeowners have the following repayment options:

• they may elect to make no repayments as long as either spouse remains in the home

• the homeowner can make a voluntary payment of the accrued interest of at least $1,000 per annum. By repaying a portion of the interest expense, this will increase the amount of equity remaining in the home once it is eventually sold to repay the loan

• the full amount of the loan is payable when the homeowners move out of the house or have both passed away

Tax Perspective

One positive aspect of the reverse mortgage program is that monies received by the homeowner are tax-free. The tax department’s reasoning on allowing the monies to be received tax-free is based on the recognition that the individual has an offsetting interest expense, even though the interest and principal may not be repaid until both homeowners have died.
A secondary issue is whether any money received is classed as “income” despite its tax-free status. Many government programs provided to seniors are dependent upon the income of the recipient. Examples of such programs include the guaranteed income supplement and the “clawback” of old age security payments. CRA has stated that amounts received from a reverse mortgage would not be classed as income for these programs.

Reverse Mortgage Checklist

If a reverse mortgage appears to be a viable financial planning option, the following checklist will outline the factors to be considered before a commitment is made to acquire such a loan.

• prepare a budget that excludes a reverse mortgage in order to assess the family’s cash flow situation

• approach CHIP or a financial institution that offers reverse mortgages to determine the maximum amount of a loan that can be arranged

• determine the current interest rate on these loans, including the various discounts and determine one’s options for locking in the various interest rates over an extended period of time

• if the reverse mortgage is an acceptable alternative, consider its effect on beneficiaries of the estate. The family home is the largest asset in many estates and a reverse mortgage will significantly dilute the equity in the home

• determine all of the costs involved with applying for a reverse mortgage. The most obvious cost is the interest rate paid on the mortgage, but there will normally be property appraisal fees, legal
fees, etc. One can expect an interest rate of up to 2% over the going rate on conventional mortgages

• determine if the rate of interest on the mortgage is fixed or does it fluctuate over the course of the loan. One should also determine how often the interest is compounded

• determine the options available if the homeowner decides to sell the home while a reverse mortgage is on the property. Will the financial institution allow the homeowner to retire the existing reverse mortgage without fees and penalties?

• obtain independent legal advice and ensure your lawyer reviews the entire arrangement before signing any contract with the financial institution

Conclusion

Although reverse mortgages are not offered by many Canadian financial institutions, they represent an option for older Canadians that are experiencing cash flow problems and see themselves as “house rich and cash poor.” However, reverse mortgages are not a panacea and are not appropriate for everyone. The interest paid on the reverse mortgage represents a direct reduction in the value of the estate. As a result, the family should consider the immediate cash flow needs of the parents vs. the effect of such a reduction in the value of the estate. If the parents have an obligation that must be funded after their death, such as a handicapped child, a reverse mortgage may not be appropriate.

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