A reverse mortgage, available to Canadians 55 and older, is a vehicle for extracting up to 50 per cent of the equity in an owned residence. Because the Canadian Home Income Plan (CHIP) requires no payment of principal or interest until the home is sold by either the owner or the estate, many seniors find this a tempting avenue for accessing some of their equity. They should avoid the temptation. Instead, a reverse mortgage should be considered an absolute last resort for the generation of needed capital.
What is the catch? Then first introduced in the late 1980s, the CHIP program met a lukewarm reception. By 2003, only 5,500 Canadians held a reverse mortgage. However, ten years later about 2,500 Canadians are signing up annually — enriching the primary provider, The Home Equity Bank, with an additional $250 million of risk-free business.
The Bank boasts that some three years ago it drastically reduced the interest rate it charged on reverse mortgages. Despite this reduction, as of early July this year, the five-year fixed-rate on offer stood at 5.45 per cent. Considering that a borrower can still secure a normal 5-year fixed-rate mortgage at a little over three per cent, the reduced CHIP rate is no bargain. And, since a five-year term is the longest offered by the CHIP program, the homeowner is fully vulnerable to the effect of rising interest rates when the five-year term expires.
Apparently, after entering the CHIP program, the average holder of a reverse mortgage remains in the encumbered home for about 12 years. Even in the unlikely event that today’s CHIP borrowing cost of 5.45 per cent remains unchanged for 12 years, a homeowner who today extracts $200,000 from his home equity using the CHIP program, will at the end of 12 years, have an accumulated interest and principal obligation totaling $384,000.
In reality, with rising interest rates on the horizon, this accumulated indebtedness is likely to be much higher. The younger the homeowner when signing up for a reverse mortgage, the greater the ballooning obligation is likely to be when the home is eventually sold.
Not only is the homeowner settling for a high borrowing cost, but he also finds himself subject to initial set-up costs of at least $2,000. In our $200,000 example, this would result in net proceeds of only around $198,000.
Most of us are familiar with the highly beneficial effects of interest compounding when applied to our investments. The reverse mortgage applies this same compounding principle — however in this case, the effect works against the homeowner, eroding at an ever increasing pace, the accumulated equity in his home.
Should a prudent homeowner always steer clear of the CHIP program?
To be fair, there is a circumstance which might make sense.
A healthy retiree who either has no heirs or no plan to leave a significant estate, may find the CHIP program of benefit. In this case, the eroding value of his equity may be of less concern — although adequate home equity may still be required to fund eventual care in a long-term facility.
Before considering the CHIP program, first exhaust all other options for enhancing cash flow. This could include deferring property taxes, or downsizing to a less expensive home.
Before making a commitment to a reverse mortgage, consult with family to see if they can suggest a better solution.
If you still feel you need to use the CHIP program, first consult with independent financial, and legal advisors, to ensure you have a full understanding of the full consequences of proceeding.
The negative factors associated with the CHIP program seem to greatly outweigh the possible benefits. I would never allow the magic of compounding, at high interest rates, to work against me, for the risk-free benefit of a reverse mortgage provider. Do not let yourself be charmed by the slick advertising of the CHIP providers — protect your hard-earned equity.
A retired corporate executive, enjoying post-retirement as an independent financial consultant, Peter Dolezal is the author of three books, including his most recent – The SMART CANADIAN WEALTH-BUILDER.
