Q: I am interested in the Pension Loans Scheme as I am on a full Aged Pension with no other income and my only assets are car, superannuation and home. At present I am topping up my aged pension with $500 a fortnight as a pension from my superannuation but this will run out in five years if we don’t have any major financial crisis.
The reverse mortgages offered by some financial institutions looked attractive on paper until you read the fine print, particularly the compounding interest and for a home of modest value and a long life, quickly became an unattractive proposition.
Will the Government charge compounding interest and can you see any disadvantages to the scheme other than that my major asset will decrease in value over time?
A: The Pension Loans Scheme operates very much like a reverse mortgage. The interest compounds until the loan is repaid, the house used as security is sold or the borrower dies. One important difference if that borrowers using the Pension Loan Scheme are paid fortnightly income and cannot receive a lump sum.
As you say, the compounding interest can eat up a lot of the value of your home over time. We do not have any data on outcomes for people using the Pension Loan Scheme but there has been some useful research on reverse mortgages.
An Australian Securities and Investments Commission review of the reverse mortgage market last year found that there was poor consumer awareness of the risk of home equity erosion over time.
ASIC warns that this lack of awareness can lead borrowers to take out large reverse mortgages that can reduce their capacity to afford important future expenses, such as aged care accommodation, medical treatment and day-today living expenses.
ASIC says: “Reverse mortgage products can help many Australians achieve a better quality of life in retirement. But our review shows that lenders and brokers need to make inquiries that would lead to a genuine conversation with customers about their possible future needs, not just a set of tick boxes on a form.”
ASIC’s review looked at reverse mortgage lending activity between 2013 and 2017. It looked at 111 loans files in detail and conducted 30 interviews with borrowers.
Each of the 30 borrowers interviewed indicated that their reverse mortgage enabled them to achieve their objectives for the loan.
ASIC’s data analysis suggested that only two out of 15,053 loans were likely to reach a loan balance that exceeds the market value of the secured property by the time the borrower reaches 84 years of age (the average age at which people enter aged care), assuming that interest rates are stable and property prices rise by 3 per cent a year.
However, if rates rise by an average of 3 per cent, about 6 per cent of borrowers are likely to rely on the no negative equity guarantee.
ASIC found that there was poor awareness of the risk of equity erosion over time. “This is concerning because our data analysis indicates that borrowers tended to apply for the maximum credit limit that had been permitted by their lender. Some borrowers reported that their broker or lender had recommended applying for the maximum possible credit limit.
“Our review suggested that most borrowers had not considered the long-term implications of taking out a reverse mortgage.
“Our loan file review indicated that the application process of all five lenders focused on the borrower’s short-term objectives, while limited or no attention was paid to their possible future needs.”
Heartland Group, which is Australia’s biggest lender of reverse mortgages, has provided an insight into what a typical loan looks like. A typical reverse mortgage on its books starts out around $60,000 and grows to $120,000 over its seven-year life, when it reaches an average loan-to-valuation ratio of 25 per cent. Most borrowers pay some of the loan off along the way, and by the time the loan is paid off the average outstanding is $113,000.
What this means is that borrowers start out with loans around $60,000 and as interest capitalises over a median term of 7.4 years the amount of debt grows to an average of around $120,000, which represents about a quarter of the value of the home.
Heartland says 77 per cent of repayments are voluntary, which means they usually occur as a result of downsizing.
It says a typical borrower has run down their super and other assets, they are receiving a pension and want to supplement that income. Typical uses for funds include renovations, travel, medical expenses, buying a car, aged care, debt consolidation, mortgage refinance, support next generation and pay everyday living expenses.
Heartland keeps track of the risk of loans entering negative equity by having an independent group monitor the loans and produce a valuation report quarterly.
Heartland has done some stress test scenarios. In one scenario property values fell by 10 per cent and then resumed growing by 2 per cent a year. The borrower is age 69 and takes out a loan with an LVR of 25 per cent. The borrower would go into negative equity territory after 29 years, aged 98.
In a much more severe scenario, the house value falls 35 per cent and there is no recovery in value through the term of the loan. With a loan on an LVR of 25 per cent, the 69 year-old borrower would enter negative territory after 13 years, at age 82.