By Sheila Avari
Advisor's Edge Magazine
Excerpt from "Know Your Client"
May 2002 Issue

Taking out a reverse mortgage for some senior clients can help them maintain a better cash flow. But is it a good idea?

Forty years ago, Joe and Maggie bought their dream home, a 1,600-square-foot, three-bedroom home in Vancouver for $36,000. Now they are both 70 and still live in the same house and, although it has aged considerably and needs extensive repairs, it is valued at $450,000. This is a common scenario in Vancouver where the price of real estate has jumped exponentially over the past decade. Increased property taxes, modest monthly pensions and small investment portfolios make living paycheque to paycheque a challenging reality. The couple needs a way to generate income to help them continue living the lifestyle they want. What are their options?

They could consider selling their home and scaling back to a more affordable condo. But the emotional attachment that comes with selling the family home can be overwhelming. And if the real estate market is not strong and the going price of the home proves to be unsatisfactory, it may help to consider other options.

A mortgage broker says he would suggest a secure line of credit, adding that a client can get one right now for as low as prime.

If both of these do not solve the cash flow problem, the couple could consider taking out a reverse mortgage. Unlike a conventional mortgage, which requires monthly payments that decrease the principal, a reverse mortgage does not require payments, resulting in debt that increases over time. Available to people over 62, a reverse mortgage gives cash strapped seniors a financial boost by turning the equity in their homes into cash.

Based on their actuarial tables, Canadian Home Income Plan (CHIP), one of the providers of a reverse mortgage, would lend Joe and Maggie $125,000. That amount in turn could be used to purchase a lifetime annuity and add to their monthly income. Upon the death of both spouses, the loan and the interest would have to be paid back by the estate. This is usually done by selling off the home.

Another financial advisor believes reverse mortgages work best for clients in very limited circumstances. The older the client the better, he says, since the client would be eligible for more money. And the senior must love the house and want to live in it for the indefinite future. Also, the client must not be too concerned with passing down an estate that includes the home.

Clients in a cash-flow crunch turn to reverse mortgages for a wide variety of reasons. Cash generated from reverse mortgages has been known to assist clients whose spouses live in nursing homes or to renovate homes to accommodate a wheelchair, says a senior vice-president of CHIP.

For seniors who still have a conventional mortgage on their home, a reverse mortgage can help pay that off first. "The first mortgage does not have to be fully paid off to qualify for a reverse mortgage," Owen explains. "If you are 70 and you have a $150,000 mortgage, CHIP could advance you $125,000 as long as there was another lender who agrees to do the secondary financing for the other $25,000."

Some clients may very well have other assets but are unable to cash them out at this time, says Owen. "A lot of clients are looking to keep certain assets in place that may have taken a hit by the downturn in the market and they don't want to pull them out and take a capital loss," she explains. "Some advisors suggest clients under 69 use the reverse mortgage to top up their RRSPs.'

More common though is the idea that seniors just want more security and a bigger financial cushion. The financial advisor tells the story of one woman who retired at 55 and came to him at 77. She lived in the family home left to her by her parents. She never married but had beneficiaries-her four siblings. Each of them were financially well off and did not wish her to leave them anything. She went to him saying she wanted to take a trip every year but didn't have the cash flow. Her income from OAS, CPP and her municipal pension was inadequate. The house was worth $425,000 so she took $130,000 in a reverse mortgage, which generated about $1,100 a month of cash flow and literally doubled her income, he says. Unable to live in the home now, she is moving to an extended care facility and is selling the home. The loan is now at $250,000 with accrued interest and the house value has jumped to $480,000. After selling the house she can keep the proceeds of $230,000.

Another senior financial planner has found creative ways to use reverse mortgages. "It can be helpful for those who would like to help their children get into their own home," he explains. "A reverse mortgage would take nothing out of the parents' bank account but it would allow them to advance a piece of their estate to their children, providing a sufficient down payment so their kids can move into the ownership market." The value of the parents' estate will have decreased but on their deaths there will be lower probate fees (estate administration taxes in Ontario).

Reverse mortgages are also highly tax-effective. The interest portion of the annuity is taxable, but the interest rolled up in the mortgage is deductible because the client has incurred that interest in order to generate income.

People should take their time before making the decision to take out a reverse mortgage. Clients should talk to potential beneficiaries but also realize the heirs are in a conflict of interest position, cautions the first financial advisor. "If [heirs] encourage the person to take out a reverse mortgage, they are reducing what they'd otherwise get from the estate:' He suggests seniors carefully assess the judgment of the beneficiaries or talk to an independent, more objective third party in order to make the best decision.

Adrian Mastracci, a fee-only investment counsel with KCM Wealth Management in Vancouver, concurs that pressure from beneficiaries and third parties can force seniors to make wrong decisions. "Senior clients in this position should become altruistic:' he says. "Elderly clients should look after themselves first and the beneficiaries get what's left over, if anything:'

Borrowing against your home for the purpose of a reverse mortgage comes at a fairly hefty cost. Currently, CHIP'S interest rate is 7.8%. Paying off the reverse mortgage within three years brings a penalty, not the reward it would with a conventional mortgage. This means equity in the home is being eaten up faster than you can say "financial freedom."

Of course, making sure clients have other adequate investments and are smart savers over the course of their lifetime would avoid this problem of borrowing on the home with a reverse mortgage.
 

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.