Selling versus reverse mortgage: which should you use?

(Credits)

There may come a time when home owners find themselves cash-strapped, yet sitting on a valuable asset: a fully paid-up house. In these situations, the common advice is to sell and downgrade. However, reverse mortgage (also called cash out refinancing) adds an alternative option. Which of the two is better?

A problem for the asset rich and cash poor

Say you need a large sum of cash, perhaps to send your child abroad to study, or to start a business. You have a fully-paid up house, but you don’t want to rent it out as you don’t want to live with strangers.

The simplest alternative is to sell the house and buy a smaller one; but there’s another way.

A reverse mortgage, lets you monetise the house without having to sell it. A reverse mortgage is essentially a loan, which uses the house as collateral. Banks can loan up to 50 per cent of the value of a house, at a very low interest rate (around 1.6 cent per annum).

If your house is valued at $1 million, for example, you could borrow up to $500,000 at a rock bottom rate of 1.6 per cent per annum. That’s far cheaper than using a most bank loans (six to nine per cent per annum), and you don’t need to lose your house.

Here’s how to pick between the two options:

When you should sell: 

1. You would be over-leveraged if you take a reverse mortgage

If you take a reverse mortgage on a fully paid-up property, for only 50 per cent of the property value, you’re not subject to loan curbs. For example, the Total Debt Servicing Ratio (TDSR) limit of 55 per cent doesn’t apply to you. But just because the government says you can, doesn’t mean you should.

As a rule of thumb, you shouldn’t allow the loan to take up more than 50 per cent of your monthly income (whatever the sources of that income may be).

It may seem great to have a huge pile of money in an instant – half the value of an appreciated house is nothing to sneeze at – but that’s seldom worth spending the next decade living hand-to-mouth.

Selling may mean moving to a smaller house; but it means having a pile of cash, without also having to worry about repayments for years on end.

2. You are getting the money on behalf of a loved one

Some people use a reverse mortgage to benefit a children or family. A typical example is a parent who takes a reverse mortgage on the condo, so that her child has the funds to start a business (At 1.6 per cent interest, it’s much cheaper than using other types of loans).

The usual arrangement is that the beneficiary of this loan, be it a child or relative, will give the borrower the money for loan repayments.

Sometimes it works out. Other times, it ends in bitter disaster that splits the family apart. Consider the social consequences, if your child or relative doesn’t give you the money as agreed: you’ll be saddled with a loan you can’t pay, and the bank may foreclose on your house. That’s going to result in many awkward family reunions.

The alternative – selling the house to get the money for them – does also means losing it. But there’s a great emotional difference between making a knowing choice to sell the house, and unexpectedly losing the house in a foreclosure (along with the sting of broken trust).

3. There are well-priced alternatives in the area

If the main appeal is location, check out other surrounding properties. If you can downgrade and buy a smaller unit nearby, without having to worry about loan repayments (e.g. you pay for the new, smaller unit at one go), that may be a worthwhile alternative.

This could be especially useful if you’re nearing retirement, and don’t want to deal with the hassle of yet another long loan as you’re winding down.

When you should cash-out:

1. The location is irreplaceable

Some things money can’t buy. Perhaps you’ve known the people in your neighbourhood for over 20 years; or perhaps you need to stay near the hospital and your children, for medical reasons.

There may be situations when you need the money, but moving is just out of the question. In those cases, cash out refinancing can be a real-life saver.

If you’re willing to complement it by taking in tenants, you can pad your retirement fund considerably even if you’re no longer working. For example, you could rent out one or two rooms to cover the loan repayment, while using the monies from the reverse mortgage to boost your retirement fund.

2. You have money coming in

If you have a lot of money on the horizon, such as through matured bonds or insurance policies, you may want to use a reverse mortgage to get the best of both worlds:

You can have immediate cash on hand through the reverse mortgage, while still retaining your house. You can worry about repaying the loan later, when your money comes in; the low interest rate makes this relatively inexpensive.

This is one of the more common reasons why people use cash out refinancing.

3. You already have the money, but want to maintain cashflow

Some people already have the money they need; they just don’t want to spend it all in one go. For example, if you have $500,000, and you want to put it into an investment, you may not want to part with all that money at one go.

Instead, you could take out a reverse mortgage for $500,000, and use that to invest. In the off chance the investment goes sour, you still have your $500,000 in your bank account, so there’s little risk of the loan going unrepaid.

As to why you wouldn’t just use a regular bank loan, the answer is again the interest rate. At 1.6 per cent, the interest on cash out refinancing is lower than almost any other loan on the market, while at the same time providing significant sums.

For other finance related articles, you may wish to read about financing for your home renovation and items to look out for before signing your home loan.