In a recent newspaper column an Authorised Financial Advisor extolled the virtues of reverse annuity mortgages also known as a home equity release (HER) arrangement.
These are financial products which allow, typically, older people who might be asset rich by way of the ownership of an expensive house but are cash poor to monetise some of the value of their property whilst staying in the property. These products effectively allow them to re-mortgage their house and spend the cash. Interest is payable but is added to the capital sum borrowed.
The advisor went on to say that in his view "these are great products as they allow people with a valuable house to travel, replace the car etc".
I'm not so sure. As with so many ideas from the finance sector, think annuities for example or interest rate swaps, the devil is in the detail. In the past these sorts of products have been, to borrow a phrase from Warren Buffett, financial weapons of mass destruction.
More about that later. Let's look at how the HER market works first. The biggest NZ player in HER is the listed company, Heartland NZ Ltd. According to Heartland it has 80 per cent of the HER market with around 4,000 customers.
According to a 2014 press release the weighted average age of individuals participating in HER arrangements was 78 years, they originally borrowed $40,000 and with interest it had grown to an average of $84,000 representing 33 per cent of the value of the property re-mortgaged.
The criteria Heartland use when assessing an HER proposition is that the applicant must be over 60 and the loan must not exceed 19 per cent of the value of the property for clients aged 60 to 64 rising to 24 per cent for clients aged 65 to 69 and so on.
From the individuals point of view risk is reduced because in the unlikely event that the value of the loan exceeded the value of the property the borrower will never have to repay more than the value of the property.
Individuals need to check out the terms of the HER agreement carefully because there are situations where loans have to be repaid if one shifts to a retirement home for example.
However the key to understanding the risk of these HER arrangements is how interest costs impact the value of the loan. According to Heartland, interest is compounded monthly, most of the loans are variable rate and the rate charged is 1.5 per cent to 2.0 per cent above the standard variable mortgage rate. The current rate is 8.35 per cent pa. But that's compounded monthly. On an annual rate 8.35 per cent compounded monthly is equivalent to 8.68 per cent pa.
Although the AFA commentator defended the higher interest rate charged on the basis that the client could live for such a long time that the value of the loan exceeds the value of the property it is pretty clear from the loan criteria Heartland use that they have this risk covered.
There is a conservative borrowing criteria employed, for example someone aged 60 is only able to borrow 19 per cent of the value of their property so interest rates would have to rise markedly and property prices not rise with interest rates for Heartland to lose money. Given that property is a good hedge for inflation and interest rates go up and down with inflation that doesn't seem a big risk. However as we all know the past can't be relied on.
On the surface these HER arrangements look like a product which has huge relevance to older New Zealanders. The property market, in Auckland anyway, has boomed and an HER deal allows Mr & Mrs Smith living in Herne Bay to get some money out to improve their lifestyle, see the kids in Canada, buy a new car etc whilst still living in their house.
Yet these HER arrangements are not a no-brainer because with inflation currently under 2.0 per cent pa an 8.35 per cent funding cost means that mum and dad's equity in a property could be reduced rather quickly.
Furthermore if interest rates were to rise dramatically and property prices fell things could go pear shaped in a short time and thus constrain the borrowers options for moving to a retirement home, shifting to a new house etc etc.
Furthermore individuals need to check out the terms of the HER agreement carefully because there are situations where loans have to be repaid if one shifts to a retirement home for example.
One particularly disastrous HER case occurred with a fixed interest rate. I was asked to check the bank's calculation of the break fee by a lawyer. The break fee was the charge, over and above re-paying the loan, that the bank required from a retired couple who had taken out a reverse mortgage loan.
The numbers were astonishing - the couple originally borrowed $150,000 and the break fee was $191,000 so in order to walk away from the HER deal the couple had to pay the bank $380,000, despite the sum of the original amount borrowed plus interest accumulated thus far being around $190,000.
Not surprisingly, when confronted with these numbers the couple wondered why? The reason for the high break-fee was that since the couple had locked themselves into a long term mortgage at 8 per cent interest rates had fallen dramatically and not only that the bank said its opportunity cost was a short term bank wholesale rate so the differential between the two numbers was about 5 per cent a year.
The bank argued that by allowing the couple to repay the loan early they would miss out on that compound interest differential and the sum of that differential in present value terms was about $191,000.
So the question for someone considering a HER arrangement is "could this happen again?" I spoke to Heartland and they advise that virtually all of their HER arrangements employ floating interest rates so the short answer is no. In addition no matter where interest rates go investors can repay their mortgage for a relatively small break-fee.
Therefore today probably the most significant feature of an HER arrangement is that it is expensive. For example if you need to move to a retirement home or shift to a new house you may have to repay the loan and with interest compounding daily at 8.35 per cent that loan can move up sharply.
For example someone who borrowed the maximum of $95,000 against a $500,000 house when they were aged 60 at 8.35 per cent and assuming 2.0 per cent house price growth would see their equity reduced to about 50 per cent in just over 15 years. If house prices fell by 2.0 per cent pa in the next 15 years the accumulated loan would represent 84 per cent of the equity.
Clearly the Reserve Bank needs to keep a close eye on the banking sector's exposure to the HER market given that many independent experts reckon that house prices are overvalued.
HER arrangements need to be thought through carefully and whilst HER providers maintain that prospective customers should get independent advice it's not all that clear who would be well qualified to offer that advice.