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Real Estate Wealth

What is the True Cost of a Reverse Mortgage?

If you own your home (i.e. mortgage free) and over age 60, you’ve likely seen ads for reverse mortgages. A 30 second ad can make a reverse mortgage appealing, however you must consider the true cost.

Note: For reference I’ve posted a couple ads below:

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Essentially, a reverse mortgage is a loan (using your house as security) on which you don’t have to make re-payments. Instead, any interest accrued on the loan simply gets added to the principal. While the thought of not making payments can sound enticing, a reverse mortgage can be one of the more expensive ways to access money in retirement.

People get reverse mortgages to access the equity in their homes to pay off debt (including a pre-existing mortgage), cover medical expenses or make home modifications. Many use a reverse mortgage – as opposed to other forms of debt – because they don’t have to make payments until they (or their estate) sell their house. This frees up cash-flow. Homeowners are still expected to maintain the property and pay all property taxes and insurance costs, or risk foreclosure.

Before using a reverse mortgage, people must be aware of the total costs. I believe there are usually better alternatives.

First of all, the interest rates on reverse mortgages tend to be higher than conventional mortgages. Home Equity Bank sells the CHIP Reverse Mortgage and provides a bar chart that compares loan rates below. Based on the information they provide, the interest rate on reverse mortgages tends to be about double that of conventional mortgages, but cheaper than unsecured loans, credit cards, etc.

I frequently say reverse mortgages are expensive, but I’ll admit they’re still cheaper than some alternative forms of borrowing. However, there is more to the total cost than the interest rate alone.

Since you’re not making interest or principal payments on the loan, interest expenses get added to the principal. This is what really drives the cost of a reverse mortgage.

Effectively, as the mortgage compounds you pay interest on interest. In other words, the amount you owe grows at an exponential rate over time. The table below – again provided by Home Equity Bank – shows how a $150,000 loan becomes $204,939 in only five years at a 6.34% mortgage rate.

If we extend that scenario to ten years, the total amount owed becomes $282,299. That’s almost double the amount of cash originally received when the loan was originated.

The CHIP Reverse Mortgage allows homeowners to access up to 55% of the value of their house. So let’s imagine you’re sitting on a fully paid-off houses in Toronto worth $909,090. Using a CHIP reverse mortgage you can borrow $500,000. As you can see in the graphic below, in ten years, you owe $940,996 – more than the value of your home when you took out the loan.

Of course, during the decade the value of your home might also rise, in which case you would still have positive equity. Regardless, in the end you’re paying $1.82 back for every dollar you borrowed. As you can see, the cost of a reverse mortgage is almost equal to the amount of the original loan.

Some borrowers might not be bothered by this – in the end it’s not their loan to repay. At death, the estate will sell the house, repay the reverse mortgage and whatever’s left over will go to the deceased person’s heirs.

However, the family unit might not want to sacrifice a million-dollar asset in exchange for $500,000, while praying the house appreciates in value over time so there’s something left over. Despite the experience in Canada over the past couple decades, housing prices don’t always rise – just ask someone who owned a Toronto home in the 1990s.

A fully paid-off house represents your lifetime of sacrifice and effort. To swap it for half its value and hope to get something in the end is a waste and a gamble, in my opinion. While history has shown that real estate prices keep up with inflation, this should not be the expectation when getting a reverse mortgage. In my opinion, any form of borrowing should be made under the most conservative assumptions.

If you or anyone you know is considering a reverse mortgage, PLEASE be aware of the true costs. Get the family together and consider whether it makes more sense for other family members to help cover retirement expenses to help preserve ownership of the house within the family. If you must borrow, consider using a more conventional loan that gets repaid over time. This will help avoid the costs of compounding.

If there are no other alternatives consider selling the house.

In this case you’d get $909,090 today. (For simplicity’s sake, I’m not considering transaction costs of either selling or entering the mortgage.) The $500,000 could be used to fund retirement costs. The remaining $409,090 could be invested and withdrawn to pay for an apartment. If your investments earned 5% and you withdrew $2,000 per month for an apartment you’d still have $361,917 after ten years. Would you have this much in equity in your house in ten years? Maybe. Maybe not. The thing is the liability is a sure thing, the asset price is not. Of course, the value of the portfolio isn’t a sure thing either. However, it is liquid and that has value.

Finally, I think it could be a great idea to use the $409,090 to purchase a larger house so you can live with the rest of your family. The money then remains in the family (as opposed to paying rent to an outsider) and everyone is together.

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Wealth

Should Parents Pay for College?

A friend of mine (let’s call her ‘Jane’) recently brought up the cost of putting her children through college. It turned out she was paying all the bills.

This would be great if she could afford it.

But she can’t.

Jane is 51 years old and earns roughly $90,000 per year. She will likely happily work for another 15 years. Currently she has about $400,000 in retirement savings and plans to aggressively save during her remaining working years.

To help her children pay for college, she has withdrawn some of her savings and tapped into a line of credit.

As a parent, I can understand the instinct to do everything you can for your children. However, I don’t believe parents should put their retirement at risk to pay for their kids’ education.

I realize I’ve probably ticked off a few people.

What is the parental obligation?

The moral argument that parents are obligated to provide an education for their children is strong. I agree that people shouldn’t have kids if they’re not willing to set them up for the world. However, what that means has evolved over the decades. Today that might mean a masters degree. But what were parental obligations 50 years ago? And what will they be 50 years from now?

The parental obligation seems to have grown over the years. Regardless, parents with college aged children today should have known what they were getting into, but at what point does the obligation end? Maybe never. I don’t know.

Of course, the decision is more than moral. It’s pragmatic. Money doesn’t appear out of thin air, and for that reason there are many additional considerations.

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Who’s paying for retirement then?

Let’s put the moral argument to the side.

There is a pressing financial issue facing parents today. The cost of post-secondary education continues to rise faster than incomes. While it is increasingly necessary to get a college education, it is also increasingly financially unattainable for many people.

This is happening while much of the world faces a retirement crisis. People simply have not saved for retirement. Jane is one of the lucky ones, yet she still faces a shortfall if she doesn’t continue to aggressively save and invest.

Jane’s ability to fund her retirement is at odds with her desire to pay for her children’s education. She probably cannot do both.

Her window of opportunity to remain self-sufficient in retirement is closing. The more she financially commits to her children’s education the less likely she will retire as planned. Of course, plans have a way of going wrong anyway. Any number of unexpected events – ill health, redundancy – can cut her timeline to retirement in half. Jane has limited time and lots of downside risk.

In contrast, her children will have 60 years ahead of them once they graduate from college. If they pay for their own education, this is plenty of time to repay debts. If they pursue the right career path, they likely have much more upside than Jane has downside. Moreover, if Jane’s retirement is adequately financed she will retain independence. If Jane sacrifices her retirement to pay for her children’s education she will invariable depend on them (perhaps even live with them) once she stops working. Whether this is good or bad is up to the family to decide, but you must recognize that each option comes with trade-offs.

The biggest trade-off for Jane’s kids if they self-fund their education is they will be saddled with debt on day 1 of their working lives. That seriously restricts their ability to take entrepreneurial risk. It also forces them to take the first job that comes their way, perhaps sending them down a path they didn’t envision. Debt is restrictive and stifling.

As you can see there are no clear cut answers (unless you’re rich), but here is what I think:

  1. The decision to go to college and pursue a stream must be carefully evaluated. College is simply too expensive to use as a place to find yourself. Students (and parents) must have a path in mind and need to fully understand the return on investment of a college degree.
  2. Education costs should be shared by both parents and children. Everyone needs a stake in the game. Not only does this reduce the burden, I believe it builds commitment. The more a student is aware of the difficulty in paying for college, the harder they’ll work to get the most out of their education.
  3. Avoid paying for college using debt. If any debt must be incurred, the child should borrow (not the parent). The downside risk for a middle-income, middle-aged parent struggling to save for retirement is simply too large.
  4. Prepare well in advance. In anticipation of college costs (even if the child is still a toddler) cut some expenses. Forgo a trip or two. Importantly, the child must participate in these sacrifices starting at an early age. And when they can get a part time job, a significant portion of their earnings should be stashed away for school.

I don’t have all the answers, but I hope I have provoked some discussion.

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Wealth

How Jeff Bezos Made All His Best Decisions

“All of my best decisions in business and in life have been made with heart, intuition, guts — not [with] analysis.” — Jeff Bezos

“When you can make a decision with analysis, you should do so, but it turns out in life that your most important decisions are always made with instinct, intuition, taste, heart.” — Jeff Bezos

“There wasn’t a single financially savvy person who supported the decision to launch Amazon Prime. Zero. Every spreadsheet showed that it was going to be a disaster. So that had to just be made with gut.” — Jeff Bezos

More from Amazon CEO and founder Jeff Bezos participates in the Milestone Celebration Dinner at the Economic Club of Washington in Washington, D.C.:

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