Dec 04, 2020
Many Canadians preparing for retirement today are house rich but cash poor as they have a significant portion of their net worth tied up in their principal residences. Those that have been lucky enough to own a home often have a net worth that appears healthy as housing prices have appreciated significantly but as they enter retirement they quickly realize cash flow is challenged. CPP and OAS cover only a fraction of monthly costs. As a result more and more people are relying on reverse mortgages as a solution to their cash flow deficits in retirement.
A reverse mortgage allows you to borrow against home equity while continuing to own and live there. You receive funds tax-free as a lump sum or as regular monthly cash flow. The loan only becomes due if you sell the home, move or when the last surviving owner dies. On the surface this is a very appealing option to those that would like to stay put and do not have enough cash flow to comfortably cover their expenses. However, relying on a reverse mortgage for cash flow over many years is a risky plan as the total debt continually increases while home equity decreases. Needless to say this is not a good combination in your retirement years with a few decades to fund.
To qualify for a reverse mortgage in Canada, you must be age 55 or older and live in your home for at least six months of the year. If eligible you can borrow up to 55% of the property’s value. There are no repayments required until the mortgage is due and you don’t need an income to qualify. Funds come tax-free and if the house value drops or interest rates rise there is no risk. At first, it sounds too good to be true. And it is. For example, reverse mortgages are expensive to set up and the interest rate charged on the loan is normally over twice as high as a conventional mortgage rate.
The market for these mortgages reached $4 billion in 2019, up nearly 30% year/year and the growth doesn’t look like it will be slowing down anytime soon as many Canadians discover they have not saved nearly enough in liquid financial assets. It’s a short term fix, with compounding long-term problems.
For example, assume you and your spouse live in a house valued at $750,000, with no debt and $250,000 in a defined contribution plan. You’re both 60 and recently retired. On the surface the financial picture appears healthy. You have a net worth of $1M and no debt. You’re both eligible to begin collecting CPP now and OAS at 65. You figure, if need be, you can unlock the equity in your home by getting a reverse mortgage at some point. Your monthly fixed and variable expenses during retirement are projected to be $5,500 but you quickly realize CPP doesn’t even cover half of that so you withdraw the difference from savings. However, withdrawals from your registered savings are taxable and therefore you have to take out a larger amount in order to cover your spending. Also, costs are continually rising every year with inflation (which has averaged over 2% annually).
Over the next few years you have some unexpected house repairs and require a new car. By the time you and your wife turn 65 your financial assets have been drained. OAS kicks in at this point but it barely makes a difference so you trim your fixed and variable expenses down to $5,000 per month. Your home has appreciated in value to $825,000 so you decide to unlock the equity with a reverse mortgage of $350,000. You take the money as a monthly deposit of $3,000 tax free so when combined with your government pensions you’re able to cover monthly expenses. It appears like you have solved the cash flow problem and all will be good.
Ten years later, the cash is gone. The reverse mortgage debt has grown to $600,000. You’re not able to trim monthly expenses which are now over $6,000 because of inflation and you cannot borrow against your remaining home equity – so you decide to sell. Let’s assume you get $1M, so after paying off the loan and transaction costs the net is less than $400,000. However, what if the house doesn’t appreciate in value much because interest rates have been rising over the years and you are only able to sell your house for $850,000? That would leave around $250,000.
You’re both now 75 and potentially have another two decades of retirement to fund. Fifteen years ago your financial picture appeared solid but now you run the very real risk of running out of financial security when you need it most. Had you downsized or rented and invested the equity, the long term picture would have been very different. We’re living longer and healthcare costs are continually rising and often faster than the rate of inflation. If you need to go to into an assisted living home in your later years your costs will rise even more.
If you are spending more than 30% of your gross monthly income on housing costs than you are spending too much. You must prepare and plan for your own pension-like income and this begins by saving and investing at least 15% of income. If most of your net worth is in your principal residence as you prepare for retirement, you’re taking on substantially more risk than you realize and should consider downsizing or renting to ensure enough is invested in liquid financial assets to support you and your loved ones for the rest of your lives.
A reverse mortgage may work for some as a short term solution but it’s not a long term plan and should only be considered as a last resort in most circumstances.
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.