What if Interest Rate on Reverse Mortgage Outpaces Price Appreciation Rate?

For many retirees, their home represents a significant portion of their wealth. Reverse mortgages offer a way to tap into this wealth, providing much-needed funds for living expenses, healthcare, or other financial needs. However, when the interest rate on reverse mortgage outpaces price appreciation rate of the home, borrowers may find themselves facing some tough decisions, particularly depending on the amount they borrow relative to their home equity.  Note:  The average yearly appreciation in Greater Toronto Area has been a little above 6% between 1994 ~ 2023. Let's delve into this with a couple of scenarios.

Scenario 1: Initial Lump Sum Followed by Recurring Monthly borrowings

Consider a scenario where a retiree, let's call her Mrs. Smith, owns a home valued at $1,000,000 with no outstanding mortgage. She decides to take out a reverse mortgage but only borrows $20,000 at the onset and chooses to receive $2200 each month at 8% interest for 20 years.

The benefits of this approach are:

1. Lower Accumulated Interest: With a relatively small loan amount compared to the value of her home, the total interest accrued over time may still be manageable, even at a higher rate. Mrs. Smith may find that the accumulated interest, although higher, is not significantly eroding the equity in her home.  Refer to the graphics below.
   

2. Flexibility in Repayment: Reverse mortgages don't require monthly payments. Instead, the loan balance, including accrued interest, is due when the borrower moves out, sells the home, or passes away. Mrs. Smith may have the option to defer repayment until a more favorable time or until her estate can handle the settlement.
   

3. Potential for Appreciation: While the rate of appreciation of real estate may be lower than the interest rate at onset on the loan, there's still the possibility that Mrs. Smith's home will continue to appreciate at a faster pace over the longer term.  The interest rate on the Reverse Mortgage will be reset at the end of the term (usually 5 years or lesser).

In this scenario, Mrs. Smith may feel relatively secure in her decision to take out a reverse mortgage, even with a higher interest rate, as she has taken a conservative approach.

Scenario 2: Entire borrowing as a lumpsum at onset.

Now, let's consider a different scenario where another retiree, Mr. Johnson, also owns a $1,000,000 home with no existing mortgage. However, Mr. Johnson decides to borrow the maximum possible $550,000 through a reverse mortgage to buy an income generating asset.

In this case, the impact of a high-interest rate would be much more pronounced:

1. Accelerated Erosion of Equity: With a substantial portion of his home's equity being borrowed, Mr. Johnson may find that the higher interest rate is causing the loan outstanding to increase at a faster pace.  While his property value and equity might still be growing much of the appreciation is eaten by the cost of borrowing. This could leave him with limited resources later in retirement or reduce the inheritance he could potentially leave for his heirs.  Refer to the graphics below.
   

2. Increased Risk of Negative Equity: If the interest rate surpasses the rate of appreciation by a significant margin for a substantially longer time, Mr. Johnson runs the risk of his loan balance exceeding the value of his home. This situation is known as Negative Equity, but Mr. Johnson would be protected as long as he meet the lender’s obligations.  Note: Reverse mortgage products offered in Canada are a lifetime product and if the property taxes and insurance are in good standing, the property remains in good condition, and the homeowner is living in the home, the loan won’t be called even if the house decreases in value.  Nor would the estate need to make up the shortfall.
   

3. Limited Options for Mitigation: Unlike Mrs. Smith, who had ample equity remaining in her home, Mr. Johnson's options for mitigating the impact of the high-interest rate may be limited. He may find it challenging to refinance or take out additional loans against his property if its value hasn't appreciated sufficiently to support the growing debt.

In this scenario, Mr. Johnson may need to carefully evaluate whether borrowing such a large lump sum at the onset could be the best option for his financial situation.  If the income generating investment, he plans to make is not too risky and can make up for the loss of equity, then it might be financially justified.

In conclusion, the impact of a high-interest rate on reverse mortgages can vary significantly depending on the borrower's individual circumstances, particularly when and how much amount borrowed relative to the equity in their home. While some borrowers may be relatively insulated from the effects of a higher rate, others could face more substantial challenges, including accelerated erosion of equity and increased risk of negative equity. As with any financial decision, it's crucial for retirees considering a reverse mortgage to weigh the potential risks and benefits carefully and seek professional guidance to ensure they make the best choice for their situation.