Topic: How To Invest

The reverse mortgage pitfalls you need to know about

reverse mortgage pitfalls

Canadian seniors may borrow on their home equity in the form of a reverse mortgage—but should they?

Money lenders are always coming up with innovative ways for you to borrow money. One such innovation is the reverse mortgage.

Interest in reverse mortgages is rising with an aging population and low interest rates on savings accounts. As a result, we hear from our Inner Circle members periodically asking whether a reverse mortgage would be a good way to tap into the equity they have built up in their homes.

Reverse mortgages in Canada let homeowners who are 55 years of age or older borrow on their home equity—the minimum age was 60 until a year ago. (For married couples, both spouses must be above age 55). Typically, the loan-to-value ratio is up to 40%. But depending on their age and property, some borrowers may qualify for a loan of up to 55% of the value of their home. The loan and accumulated interest are repaid only after the house is sold or from the proceeds of the homeowner’s estate.


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Reverse mortgages are best seen as loans of last resort

From the point of view of someone looking at a reverse mortgage for their own home, we see them as appealing for real estate owners only in highly specialized circumstances. You’d want to use a reverse mortgage only if you feel that selling your home is out of the question, AND if you’ve exhausted all sources of income that do not involve heavy costs such as loss of tax deferral or a big tax bill.

One of the biggest reverse mortgage pitfalls is that their immediate appeal can lead real estate owners to not consider all of their lending options available to them. Make sure you look at all other housing or financial options open to you. If none of these are more appealing, only then should you consider taking out a reverse mortgage.

For example: What are the initial costs, such as the application fees and the house appraisal? What are the ongoing costs and the interest rate? What are the exit costs (i.e., is there a penalty for getting out of the plan early, are there additional legal fees or real-estate fees)? You’ll need to seek out and pay for independent legal advice, as well. Costs are one of the most overlooked reverse mortgage pitfalls.

Real estate investing: Compound interest could work against you

If you are only planning to hold on to your home for a few extra years, it may be a lot cheaper to take out a mortgage-backed line of credit. If you plan to hang on to a home for a longer period, a reverse mortgage may be your only way of doing so. But keep in mind that the interest on a reverse mortgage compounds, just like the interest on a strip bond. When you leave the home, the principal and interest must be repaid.

In fact, instead of “reverse mortgages,” it might be more accurate to call these deals “reverse savings accounts.” That’s because you are applying the much-acclaimed “magic of compound interest” to a debt rather than an asset. It will work just as relentlessly against you as it does when it is working on your behalf.

Why do you need the money?

This is an important question to ask when considering a reverse mortgage. While most people take on a reverse mortgage to pay their day-to-day bills, some investors may contemplate using the funds from a reverse mortgage as a way to “borrow to invest”.

Borrowing money to invest can be a viable option, and a reverse mortgage may be a means to acquiring that capital. But as with all the reverse mortgage pitfalls discussed above, borrowing money to invest only makes sense in certain situations.

As a general rule, you should be borrowing money to invest in stocks after a drop, rather than when the market has steadily risen for several years. We think you’ll benefit most from this buying opportunity by sticking with the kind of stocks we recommend, as well as ETFs we like.

But borrowing to invest is not without risks, including the risk of increasing your leverage. The amount you owe on your investment loan will stay the same, regardless of what the market does, but every dollar your portfolio gains or losses will come out of your equity. In addition, if you take out a variable-rate loan, the interest rate you pay could eventually rise above the return on the fund.

Borrowing to invest only makes sense if all six of the following apply:

  • You are in the top income-tax bracket and expect to stay there for a number of years;
  • Your income is secure;
  • You have 10 or more years until retirement;
  • You follow our low-risk investment approach;
  • You have the kind of temperament to sit through the inevitable market setbacks without losing confidence at a market bottom and selling out to repay your loan;
  • You have already made your maximum RRSP contributions.

After reading about the reverse mortgage pitfalls, are you more likely to move forward with one? Let us know what you think in the comments section.

Note: This article was originally published in 2012 and has been updated.

Comments

  • Dirk S.

    Excellent and helpful article. Think 20x before doing one of these. I’ve been often tempted to do a reverse mortgage to realize funds for investment purposes. A wise spouse stops me. It would be like adding risk to risk.

  • Lloyd D.

    I think that there should be a law aginst the type of advertising that is done on TV regarding reverse mortgages – such as stating that the idea is recommended by bankers and investment advisors.

    Also the true reason the guy is crying should be explaned.

  • Elizabeth

    I have wondered about using a reverse mortgage to buy a city pieds-a-terre. I have pretty much abandoned the idea but it seems to me to be the one situation where I would use this method of financing. The idea is that should we have to leave our house in the country (we are seniors) we would already have a place in Montreal – bought at today’s prices. However, I find (1) there are a lot of expenses with reverse mortgages and (2) I am not at all certain that Montreal condo prices will continue to rise. Bottom line is I’m not sure we can afford two places considering taxes and condo fees.

  • Isn W.

    Dear Sirs:
    Though not in the market now – or hoepfully ever – for a reverse mortgage, I sgree with you that to me it is a loan of “last resort!”

    However I think it’s really even more so because potential lenders are not looking at the real market need for seniors!!! I have asked but never got even a half-answer!

    What is really needed is a mortgage that is REALLY a reverse mortgage. Seniors generally don’t want a lump-sum up front (to keep in the bank at 0.001% interest!) but a flow of cash to supplement their income.

    So why don’t lenders offer a true reverse mortage which would compute and lend a stream of payments (at interest of course, but hopefully a rate reflective of the low risk given the high property value/ loan ratio) rather than a useless lump sum which has seniors paying pretty high mortgage interest rates on a large amount of loan, rather than a interest on the (rising) amount of loan as the stream of payments accumulated. Surprise: like a regular mortgage in reverse!!!

    If I had the large pool of capital to do so, this is what I’d offer. With web banking available to make the payments, and computers to keep track of the loans and data – this would be a guaranteed get rich-quick scheme! Retirees would be pounding at my door. And with proper use of loaded mortality payments the risk at any point, while increasing with time, would be negligeable!!!

    Just an opinion from a retired and dumbing C.A.!

    Ian

  • Ilene K.

    Dear Pat,

    I agree with all of the commentary…. reverse mortgages are only a loan of last resort. However, if you are still anxious to go ahead, think about it. If you qualify for a reverse mortgage, your property has perceived value. Therefore, if you need money, sell it, move into something more affordable and bank the difference! All of your money then belongs to you.

    Ilene

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