Making Sense of Reverse Mortgage Rates
Paul von Martels. February 1, 2019
When it comes to any lending product, the mind commonly goes to two places— how much will I get and how much will it cost me?
This post will focus on the “how much will it cost me” part, since interest rates for reverse mortgages are often misunderstood, especially when compared to other lending solutions.
It’s important to remember that comparing interest rates across lending products is a difficult task, and often not a productive one, as lending products and their terms differ in many ways.
So how does a potential borrower make sense of it all?
The first crucial distinction is secured credit versus unsecured credit. As an example, a reverse mortgage is secured against a home (principal residence), whereas a standard credit card is unsecured. In the secured option, the lender can collect assets in the event the borrower defaults, whereas in the unsecured scenario, that recourse isn’t possible. This important difference contributes to the much higher interest rates of unsecured products such as credit cards (i.e. 19% to 30%) or unsecured lines of credit (7% to 10%), as the lender is assuming a lot more risk and needs to offset that risk with interest. It also explains why unsecured credit limits are so much lower than secured lending alternatives. In banker-speak, the probability of default is higher and the loss given default is lower.
With risk management playing a significant role in determining rates, let’s further explore the rates of a reverse mortgage—which falls under the secured lending scenario.
At the time this article was published, Equitable Bank Reverse Mortgage rates ranged from 6.00% to 6.74% depending on the term (click here for the most up-to-date rates). The going rate on an uninsured standard (e.g. amortizing) mortgage is about 3.69%, and for a secured line of credit it’s approximately 4.5%-5% (which is the Prime Rate + 0.25%). In addition to offering prime insured mortgages, lenders like Equitable Bank also offer alternative mortgages, which carry annual interest rates between 4.5% and 6% (with a 1% upfront fee). Private mortgages, another common loan type, often start at a rate of around 7% and can go much higher than that. Private mortgages typically carry an upfront fee that—starting at 2% of the loan amount— may require annual interest payments to be made. As mortgage rates change frequently, it can be helpful to speak to a mortgage broker to stay on top of the changes.
As you’ve noticed, there’s quite a variance in loan rates. Let’s further explore the topic of risk to understand why.
A helpful fact to remember is that standard mortgages and home equity lines of credit (HELOCs) are assessed and granted (or declined) based on the borrower’s ability to make regular payments. This knowledge results in a lower risk of default for those customers who are approved (with the lender not obligated to renew.
The structure of these products also differs from a reverse mortgage. With standard mortgages and HELOCs, borrowers make regular payments, which represent the return of interest and principal for mortgages (some HELOCs often require interest-only payments). Because a reverse mortgage doesn’t require any regular payments, the reverse mortgage lender often waits years for their principal and interest to be returned. For another perspective on this, check out Rob Carrick’s article in The Globe and Mail (here) where he discusses the challenges some senior borrowers experience with HELOCs and rising interest rates.
As you can imagine, lending money for an undefined number of years without any scheduled repayments bears a greater risk to the lender, resulting in a higher interest rate for the borrower. The benefit to borrowers, of course, is getting access to tax-free cash, without having to make regular payments.
With a reverse mortgage having a higher interest rate due to higher risk to the lender, a question that’s sometimes asked is why Equitable Bank’s loan-to-value (LTV)— the amount of money the bank is prepared to lend in proportion to the value of the property—seems so low. People sometimes wonder if there’s really a risk to the bank, when the LTV isn’t particularly high. The short answer is yes, there is a risk, due to uncontrollable factors like real estate cycles, inflation, and the amount of time a reverse mortgage customer will have his/her mortgage outstanding (as reverse mortgages do not have maturity dates). The following scenario illustrates these factors at play:
A borrower takes a $196,000 Equitable Bank Reverse Mortgage at the age of 73 on her $700,000 home in Mississauga, ON. The borrower is in good health, and chooses to remain in the home for 20 years before selling. Since money is tight, she does not make any principal or interest payments over the 20-year period. During that time, the housing market in her Mississauga neighborhood not only slows, but does not appreciate. Interest rates also increase slightly at each rate reset period**. At the time of selling at the 20-year mark, the property is sold for $700,000, and the value of the loan’s principal and interest is $738,640—in other words there is a $38,640 shortfall. Equitable Bank assumes this shortfall, as the borrower will never owe more than the fair market value of the property—plus the cost of selling—to Equitable Bank. This— that the borrower will owe no more than the fair value of their property—is an important feature of Canadian reverse mortgages. You can try out different scenarios using Equitable Bank’s Reverse Mortgage calculator.
While the above scenario is unlikely, it illustrates the level of risk the lender assumes, and since this scenario could happen on a large portfolio of loans experiencing similar market factors (versus the single one in the above example), the risk could be magnified.
For some additional context on how banks arrive at the interest rates they charge for reverse mortgages, it’s also necessary to include the Bank’s costs. The bank gathers funds from its deposit holders in order to offer lending products. To entice more deposits, they offer interest to their customers.
As an example, EQ Bank—the digital arm of Equitable Bank—has a savings account that offers 2.45% everyday interest* to its customers, which ultimately is a cost to the bank. Financial institutions also incur expenses related to the cost of reviewing applications, technology, servicing a mortgage over its lifetime, and compensating the mortgage broker for helping to arrange the mortgage.
Now that we have some context behind reverse mortgage rates, it’s easier to understand that not all loans—or mortgages for that matter—are created equal. Your best bet is to compare loans with similar terms from respectable lenders. Responsible lenders, and more specifically Schedule I Canadian banks like Equitable Bank, are regulated to ensure they operate professionally and can withstand economic volatility, so that borrowers and the Canadian public are not put at risk.
Equitable Bank is in it for the long term, which affects the way loans are issued and priced.
For the potential borrower like yourself, knowledge is power, and the better understanding you can gain about the process, the better you’ll be able to determine if a reverse mortgage meets your financial needs.
*Interest is calculated daily on the total closing balance and paid monthly. Rates are per annum and subject to change without notice.
** EQB offers fixed and adjustable interest rates on its Reverse Mortgages. Clients choose from 1-5 year interest rate reset periods which determines when the existing interest rate is updated. Speak with your broker to learn more about how a reverse mortgage interest rate reset differs from a standard mortgage term.