Reverse Mortgage: Does It Work For You?
What would you ideally need to retire? A steady flow of income, a sizable corpus, and a sense of financial security. Imagine you saved consistently but invested predominantly in real estate. Upon retirement, you would find that while you were still well off you might be strapped for cash. Today, young people aspire to own their own homes and buying a house is easier with higher disposable incomes and better access to home loans. So, rental income may not be as lucrative or reliable as it was before. Investments in property are capital intensive and they tend to skew asset allocation in their favour. While owning real estate imparts a sense of financial well-being it does not offer liquidity. But, financial independence is integral to a financial security. So, could a reverse mortgage be the solution for someone who is heavily invested in real estate?
What is a Reverse Mortgage?
Think of it as the opposite of a home loan. Under a reverse mortgage, you pledge your house to the bank, who in return offers to pay you in regular intervals over a period of time. The advantage of a reverse mortgage is that you and your spouse own the house through your lifetimes.
This means that you remain responsible for the upkeep, insurance, and taxes due on your property.
Depending on the payment structure you use, you may receive an inflow for a fixed term (Regular Reverse Mortgage Loan – RML) or throughout your lives (Reverse Mortgage Loan Enabled Annuity – RMLeA).
Reverse mortgages are typically offered only to senior citizens.
Banks allow you to structure your payments regularly or as a lump sum. You can also do combination of both through either a normal reverse mortgage loan (RML) or one that is converted to an annuity (RMLeA). It’s important to understand the features of each option.
RML: The RML offers payments for a fixed term. You would receive no income if you survive the term of the loan. The maximum term that RMLs offer is twenty years but it could also be lower depending on the bank. The payments made by the bank are linked with the principal borrowed. The income you earn from the bank under an RML is currently not taxable.
RMLeA: In the RMLeA, the bank transfers the loan payment to an insurance company who would purchase an annuity on your behalf. You would continue to receive annuity payments (pension) until your death. The income you earn from the annuity is taxable.
The Fine Print
For starters, the loan issued will not be equal to the value of the house. Banks issue a loan based on the LTV (loan to value) percent, and not the actual market value of the property. The LTV depends on various factors such as the location of the property, the borrower’s credit history, the bank’s policies, etc. The LTV normally ranges between 40 per cent to 60 per cent of the value of the house.
Additionally, RML have higher interest rates (11 per cent per annum currently) than housing loans (8.3 per cent-8.7 per cent). Since the title is never transferred to the bank, at the time of settlement, the tax liability will fall on to the legal heirs.
The RML can be settled in two ways. Either your legal heirs buy back the house by settling dues with the bank (principal and interest payment). In this case, they would be eligible for only one year of tax benefits (at present the maximum deduction is Rs. 1.5 Lakhs of principal and Rs. 2 Lakhs of interest) on the home loan payment. Or, the bank could sell the property. The legal heirs would be entitled to any profits but would be liable to pay capital gains on the sale. This is applicable to both RMLs and RMLeAs.
There are restrictions on what you could do with the lump sum that the bank pays you – for instance you cannot invest in equities. Over and above this, you would have to pay a processing fee and there may be other associated charges.
Reverse mortgages are expensive financial products. They limit your investment options considerably and are tax inefficient. They could also be cumbersome for your legal heirs.
What Are Your Alternatives?
If you are keen on financial independence, you could liquidate your real estate assets and downsize to a smaller apartment. Contrary to popular belief, renting makes more financial sense than buying real estate. The problem with annuities is that you don’t have access to your entire capital. If you like the concept of a reverse mortgage, you could directly enter into an informal agreement with your children instead of using an intermediary like a bank. Financially speaking this might be a better solution for the family.