reverse mortgages canada - how to live on your home equity

A retirement fallback plan

Illustration By Chris Gash

After Charles Prusky was forced to retire from his job as a machinist-welder at 58due to illness, it wasn’t long before he and his wife Anne ran out of savings. Thatmade the B.C. couple wonder how they could make ends meet with no employerpension and limited government benefits. The Pruskys had already downsizedonce, but fortunately still owned a modest three-bedroom bungalow outsideKelowna. So they wondered: how could they best use the equity in their house toprovide the necessities of life?

As they soon discovered, planning for retirement comes with the risk of a seriousand unexpected setback. If you’re a homeowner, however, you at least have afallback plan. You should always plan to accumulate enough savings to fund yourexpected retirement needs, but if you ultimately face financial misfortune,tapping your home equity can make up the difference. What’s the best way to dothat? In what follows, we describe three common strategies, each of which thePruskys considered: a reverse mortgage, a home equity line of credit (HELOC),and downsizing or selling.

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Going in reverse

A reverse mortgage is a loan you don’t have to pay off—or even make paymentson—until you sell your home or die. So it helps house-rich but cash-poor seniorswith limited incomes find a source of funds without ever being forced to sell.

The reverse mortgage is a niche product offered by HomEquity Bank’s CanadianHome Income Plan (CHIP), the sole major provider in Canada. You can purchaseone directly from CHIP or by referral through mortgage brokers, financialplanners and other advisers.

Consider a typical example, based on details provided by CHIP. Say you’re a73-year-old couple in Edmonton who have run out of savings but own amortgage-free house worth $400,000. You could take out a reverse mortgage for$175,000, or about 44% of the value of the house. If you want to bolster yourincome over a long period, you might take $20,000 as a lump sum—perhaps tocover needed home repairs as well as set-up fees—and also take $500 a monthgoing forward.

The $175,000 credit limit is guaranteed, but how long the $500 payments lastdepends on the loan’s interest rate, which in this example is adjusted every sixmonths. The overall credit limit could be increased at some point because ofrising home values, although that is not guaranteed either. If interest rates don’tchange and the credit limit isn’t raised, the $500 monthly advances couldcontinue for 15 years until the amount you owe reaches $175,000. In that case,you’ve had the benefit of an extra $110,000 in spending over those 15 years,while the accumulated interest cost would be about $65,000. You would havekept your house and—assuming prices didn’t drop precipitously—retained mostof your home equity. After you reached the limit you would still be able to stay inthe house and the loan would continue to accrue interest, but you wouldn’t beable to draw additional funds. When you ultimately die or sell the house, theloan is paid off in full.

Reverse mortgages have some uniquely attractive features. “You can stay in yourhome forever. You don’t have to make payments and it’s pretty easy to getapproved,” says Robert McLister, mortgage broker and editor ofCanadianMortgageTrends.com. Of course, this comes at a cost. You pay a higher


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rate of interest than you would for a conventional mortgage: currently 4.99% fora variable rate or a six-month term, which is about 1.5 percentage points morethan you’d pay for a HELOC, McLister says. If you go with a five-year fixed rate,you’ll pay 5.79%. (CHIP gives you half a point off if you pay the interest as it’sincurred, as you are required to do with a HELOC.) You have to be at least 55 toget a reverse mortgage, and your borrowing capacity is limited to 50% of thehome’s appraised value, depending on age and location.

There are also hefty fees and restrictive rules on reverse mortgages. Plan onabout $2,300 in setup fees, McLister says, although a big chunk is currentlywaived if you go with a five-year term. Additional lump-sum advances must beat least $10,000 and the standard fee is $50 a pop (although that is also currentlywaived). Moreover, there can be early prepayment penalties, which areparticularly onerous in the first three years (they’re waived if you die or halved ifyou move to a nursing home).

In the past, many financial experts advised against this product, but HomEquityBank has made improvements in recent years. “Reverse mortgage rates are aheck of lot better than they used to be,” McLister says, adding that CHIP variablerates got as high as six percentage points above prime in 2009. Also, reversemortgages were once available only as lump sums. That wasn’t convenient forseniors looking to supplement monthly income.

““RReevveerrssee mmoorrttggaaggee rraatteess aarree aa hheecckk ooff lloott bbeetttteerr tthhaann tthheeyyuusseedd ttoo bbee ..””

People who borrow from CHIP usually do it for important, practical purposes likepaying off higher-interest credit-card debt, covering home-care costs, makingtrips to visit children, or just helping with day-to-day expenses. “We don’t hearmuch about clients using it for frivolous things like world cruises,” saysHomEquity Bank president Steven Ranson.

In the end, it’s up to you to determine whether the costs and restrictions areworth the obvious benefits. As Ranson puts it: “Our view is you pay a bit of apremium in return for getting to stay in your home as long as you want, and you


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never have to make a payment and never have to requalify for the loan.” There’ssimply no other way to get those features. At least the interest and principalcompounds quietly in the background and is then deducted from the proceedswhen the home is eventually sold.

When you put everything together, a reverse mortgage can make a big

difference, as you can see in the table, “Using a reverse mortgage to get by [1].”We continue with the example of the 73-year-old couple with a $400,000paid-for home who took out a reverse mortgage with a monthly draw of $500($6,000 a year). A typical couple with no savings might expect $32,000 incombined federal benefits, so the reverse mortgage would increase their cashflow by almost 20% to more than $38,000, which they can enjoy tax-free andwithout impacting their Guaranteed Income Supplement entitlement.

Putting it all on the line

If you want to save on interest costs, you may be able to borrow through a homeequity line of credit. HELOCs have more attractive rates than reverse mortgages(currently prime plus 0.5%, or 3.5%) and you can borrow up to 65% of the home’svalue. Moreover, you can take money out when you need it instead of receiving itin large lump sums or regular monthly payments.

HELOCs are designed for people who have sufficient income to pay at least theinterest each month. So if you’re an income-strapped senior, there’s a goodchance you won’t qualify even if you have tons of home equity. If you don’t havemuch income but do somehow have a HELOC—maybe you qualified before youretired—you might be able to borrow from the line of credit to pay the interest.However, that strategy can backfire because the bank may review your credit andcut your limit. They may even call the loan (requiring you to repay the balanceimmediately) if they decide your creditworthiness is deteriorating.

“If you miss payments on a HELOC, or if your spouse dies, it can be called in,which is a real concern,” says McLister. A couple may get approved for a HELOCbased on combined pension income, but if one spouse dies and the pensionincome is cut back it would reduce income available to service the loan. If you


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run into trouble with a HELOC, you might be forced to sell your home beforeyou’re ready.

If you keep those risks in mind, HELOCs can make sense for seniors in certainsituations. Say you need a lump sum, have lots of home equity, and also have agreat employer pension, even though you have little in savings. In that case, youmay have enough income to pay the interest and reduce the risk the bank mighteventually cut you off. Just make sure you still have plenty of income to pay theHELOC interest after the death of either spouse, and remember even then there’sno guarantee your credit limit won’t get cut back.

Another possibility suggested by McLister is for seniors in their 70s to start offwith a HELOC with a balance no higher than 20% of the home’s value. Thatwould provide lower interest rates to start with, but also plenty of extraborrowing capacity that should let the homeowner switch to a reverse mortgagelater on, if need be.

Dropping down a size

Downsizing or selling your home to free up cash makes most sense when thereare also non-financial reasons to move. A large house and garden can become aburden, and stairs can become a risk as you become less mobile. There may comea time when moving to a condo or bungalow is attractive. Or you may be ready tomove to a warmer climate, be closer to children or grandkids, or away from thebustle of a major city. If you plan to move for one of these reasons and you alsoneed extra cash, it’s natural to buy a cheaper place so you can pocket thedifference. If you’re ready for a retirement or nursing home, the proceeds fromselling your home can help fund the cost of those facilities.

On the other hand, if you love your home and continue to function well in it,downsizing is probably not the best way to tap the equity. Not only is there anemotional price to giving up the place you love: there are also hefty transactioncosts. These include real estate commissions, legal fees and disbursements,home inspection, moving, sales taxes, and land transfer tax in most provinces.

The transaction costs of selling a $450,000 house and buying a $250,000 condo


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could easily amount to $40,000. So in that case you spend $40,000 to net$160,000. By comparison, if you were to take out a reverse mortgage for$162,300 to net $160,000 after closing fees, you could enjoy your home foranother seven or eight years before the accumulated interest reached that$40,000 break-even point (adjusted for inflation).

The bucks stop here

Whichever method you choose, tapping home equity is a major decision thatneeds to be thought through. This is probably your last major pool of money, souse it wisely, particularly if you’re still fairly young and active. Once it’s gonethere may not be much left to pay for needs that arise later. These includehealth-related expenses like home-care workers, renovating a house for reducedmobility, or moving to a retirement or nursing home. Having extra money inyour 80s—when such challenges are most likely to arise—can make a bigdifference.

Generally, you should run down financial savings before tapping home equity.That’s because you pay more to borrow than you can earn from safe investments,especially after tax. A five-year reverse mortgage costs 5.79% (plus set-up fees),and you’d be lucky to earn 3% interest on a five-year GIC. If you invest in stocksyou may do better, but you’d amp up risks and could end up doing far worse. (Ifyou’re eligible for GIS, it’s wise to hold some money in a RRIF and keepwithdrawals as small as possible while using a reverse mortgage. That’s becauseRRIF withdrawals reduce your GIS entitlement but reverse mortgage draws donot.)

As for the Pruskys, they had already downsized once and wanted to stay in theirmodest bungalow. They’d looked into a conventional mortgage and HELOC, butdidn’t qualify because of limited income. So they went with the reversemortgage, borrowing $50,000 against the $225,000 value of the home. Thosefunds covered basic expenses until Charles passed away three years later andAnne a year after that. “It really improved the quality of their life,” says daughterJudy Sennett, a financial planner with BMO Investments in Vernon, B.C.

Seniors often worry a reverse mortgage will result in nothing for the kids, but the


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conservative lending limits usually ensure there’s plenty left in the estate. Withthe Pruskys, the loan had only grown to $58,000 when they passed on, a modestproportion of the home’s $250,000 value by then. When Sennett sees clients in asimilar situation, she doesn’t hesitate to recommend a reverse mortgage. “Ifpeople want to stay in their house and need the extra cash flow, this is often thebest way to do it.”


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reverse mortgages canada - how to live on your home equity

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