The issue explained: Reverse mortgages to support retirement

Government has proposed a new scheme to address underfunded pensions and rising social welfare costs for the elderly: reverse mortgages.

The underlying premise is that many property-owning pensioners have an untapped asset, in the form of their family home, and not enough cash and pension payouts to fund their needs in retirement.

After having paid down a traditional mortgage for most of their working lives to own their own homes, much of the net worth of low- and middle-income retirees is tied up in a single property.

To monetise that asset and convert it into cash, the homeowner would have to sell and downsize.

This is a dramatic change of lifestyle that many would rule out as an option, not least due to the emotional attachment to their home. Most pensioners worldwide consistently report in surveys that they prefer to live out their retirement in their family residence.

There are home equity loans available from banks that enable homeowners to borrow using their property as security. But these loans have qualifying criteria like good credit standing and permanent income, and require regular loan repayments.

What is a reverse mortgage?

A reverse mortgage is also a credit facility that is secured against a residential property.

However, with a reverse mortgage, borrowers do not need to make repayments until a specified event occurs. The loan balance typically comes due when the borrower sells the property, moves permanently or passes away.

When the homeowner dies, the heirs may choose to repay the mortgage but frequently the property must be sold to satisfy the reverse mortgage loan.

Until then, the home equity is converted into either a lump sum, regular cash payments or a line of credit that can be used to afford a better quality of life during retirement.

Finance Minister Chris Saunders suggested that reverse mortgages could reduce government payouts for social assistance to the elderly.

To this end he plans to “to build a fund to allow elderly homeowners to use the equity in their homes to support themselves”.

He said, “It is not fair or sustainable for the government to be assisting the elderly when they are equity-rich but cash poor.

“We believe the right and fair thing to do is to let our seniors access their cash when they need it, which is now. This will ensure that our seniors can live with dignity without being a strain on the public purse.”

Public or commercial?

Caribbean economist Marla Dukharan said in an article released on her website last week that reverse mortgages would enable borrowers to still live in their property while monetising the asset.

“If it is indeed the case that there are many Caymanians who own property and need financial assistance which they receive from the government (or anyone else), it makes sense for them to take reverse mortgages to supplement their income and eliminate the need to ask for help,” she wrote.

“However, based on my cursory assessment of the situation, I do not believe that it is necessary or prudent for the government or any state-owned entity to engage in this type of activity.”

She said given that Cayman has one of the best-regulated financial sectors and domestic commercial banks are well capitalised and liquid, financial institutions would be best-placed to go to the market with a reverse mortgage product.

“Reverse mortgages have the potential to improve the lives of Caymanian homeowners and reduce the government’s social welfare bill, while giving the banks an opportunity to mobilise their liquidity,” Dukharan said.

This approach would be a win for everyone involved.

“The banks are better-equipped to deal with the property that they will end up owning at the end of the reverse mortgages. I can’t imagine that the government is equipped to handle nor would want to be burdened with this type of activity,” she added.

Asked by the Cayman Compass whether the obstacles to offering reverse mortgages in Cayman were legal or commercial, the Cayman Islands Bankers Association said there is currently no legislative framework in place for this financial product and CIBA could therefore not comment further.

International experience is mixed

In Australia, commercial home equity release offerings exist but increased scrutiny and growing compliance costs saw many banks exit the business, according to a 2018 review of reverse mortgages by the Australian Securities & Investments Commission.

Lenders cited more intensive capital adequacy requirements, longevity risk, limited access to wholesale funding and low interest rates as reasons why many new lenders are unlikely to offer a reverse mortgage or other equity release products in the near future, the commission said.

In response, the Australian government released its own Pension Loans Scheme but the take-up was very limited – only 5,100 of the country’s 4 million pensioners accessed it.

The Australian government therefore revamped the programme and will relaunch it, with a reduced below-market interest rate of 3.95%, as the Home Equity Access Scheme in July 2022.

Another Australian government commission found, “Most older Australian home owners on low incomes could achieve a modest retirement living standard over the remainder of their lives by drawing on their home equity.”

Consumer research in the country indicated that taking out a reverse mortgage helped borrowers maintain their current living arrangement with less financial stress. Many used it to obtain short-term finance and as a safety net for living expenses.

Most Australian borrowers reported that unforeseen events like a divorce, pension fund losses, poor health, early retirement and higher costs of living had driven them to consider a reverse mortgage.

Risks remain

Researchers from the University of Wollongong and Macquarie University noted that some risks remain for those who participate in the scheme.

This includes that some borrowers may live long enough to hit the mortgage ceiling, leaving them unable to take out any more money. Those who count on their home’s equity to fund aged care services, for example, could find themselves out of pocket.

Taking out a lump sum early increases the payable interest. Because the effects of compound interest are generally not well understood by many consumers, borrowers can underestimate how quickly their home equity can deteriorate.

This risk of using up the available equity more quickly than anticipated is amplified by the fact that neither the interest rate nor home prices are fixed.

If home prices decline or do not grow as expected or interest rates rise, the value of a home can be quickly eaten up by the repayments, they found.

If the property owner passes away, borrowers or their estate are often not able to pay off the loan balance other than through selling the secured property.

This will force anyone else who lives in the home, such as family members, to move out, unless there are tenancy protection provisions allowing them to remain for a period of time.

In the US, reverse mortgages are offered by commercial banks but regulated and administered by the Federal Housing Administration.

Both Australia and the US have taken steps to establish “a no negative equity guarantee” to eliminate the risk to consumers that they must repay more than the value of their secured property at the end of the loan.

In the US, an insurance pool covers the lender’s risk that the property value at some point could fall below the loan value.

Still, in a 2019 report, the US Government Accountability Office found that defaults on reverse mortgages increased from 2% of loan terminations in 2014 to 18% in 2018.

This was mainly because the borrowers failed to comply with loan terms and conditions such as occupancy requirements or staying current on property taxes and hazard insurance.

When this happens the borrowers risk foreclosure and the loss of their home.

Although the FHA allowed loan servicers to put borrowers who are behind on property charges onto repayment plans to help prevent foreclosures for these seniors, only 22% of these borrowers were offered that option, the GAO report noted. The GAO, as a result, made nine recommendations to improve oversight of the programme and participating financial institutions.

Reverse mortgages in the US have faced additional criticism over high interest costs and expensive fees, and their potential impact on a borrower’s eligibility for social services like Medicaid or Supplemental Security Income.

They are frequently described as a complex product that is difficult for seniors to understand.

Suitability remains unclear

Determining if taking out a reverse mortgage makes sense depends entirely on the personal circumstances of the borrower and the costs of the loan.

There are currently no details on what such a scheme could look like in the Cayman Islands. Nor is it clear how many elderly property owners are reliant on government’s social services payments that could be avoided by taking out a reverse mortgage.

Regardless of whether such a product is offered by government or the financial sector it will have to be extremely well regulated and managed.

The experience in other countries has shown that there is some commercial reluctance among banks to offer home equity release products.

There is equally a question mark over government’s experience and wherewithal to enter a business that by definition will often result in the loss of the Caymanian borrowers’, or their heirs’, family home.