by Ellen Roseman

From "The Star" Sunday July 20^th 2003

Reprinted with the permission of the author.

(Every attempt was made to ensure this is an accurate copy of the text)

Last week's cut in the Bank of Canada's key interest rate is good news if you’re paying off a mortgage, since your payments may come down when it's time to renew.

But lower interest rates are poisonous for senior citizens, whose cost of living seems to be rising as quickly as their GIC returns are falling.

Seniors are often seduced by the siren song of the reverse mortgage. It's heavily promoted by the Canadian Home Income Plan, the leading national provider, as an alternative to cashing in investments and paying tax on the reduced value.

What is the downside of a reverse mortgage?

That's a question I hear all the time. People want to know what's not disclosed in the company's newspaper advertisements and TV commercials featuring financial author Gordon Pape.

Let's look at a fictional couple, Jean and Jerry, living in Toronto in a house worth $400,000. They're 70 and 72 the average age, when people take out a reverse mortgage. (You have to be at least 62 years old to qualify.)

With a CHIP reverse mortgage, they can get a lump sum payment of $120,000 — 30 per cent of the value of their home — to spend as they please.

Before they get the cash, Jean and Jerry have a few bills to pay.

They need a home appraisal ($150 to $200) and independent legal advice ($250 to $400).. Plus, there are CHIP closing costs of $1,285.

Still, they have the comfort of staying in the home and neighbourhood they know so well, with the support network they've built up there. They won't have the pain of uprooting, moving and downsizing.

A reverse mortgage requires no repayments. The interest compounds and is added to the balance of the mortgage.

The CHIP mortgage currently has an interest rate of 7.25 per cent This compares to 7.8 per cent on a 10-year conventional mortgage from a major bank.

But unlike a conventional mortgage that carries a fixed rate, CHIP resets the rate on its outstanding reverse mortgages every year.

This gives homeowners little protection if there's an upward trend.

Assuming the CHIP rate stays constant at 7.25 per cent, Jean and Jerry will owe $240,000 — or twice the amount they received — in 10 years. That's how a rising-debt mortgage works.

(Using the rule of 72 that applies to compound interest, you take the interest rate and divide it into 72. That's the time it takes for your assets to double if you're investing or your debt to double if you're borrowing.)

So, if Jean and Jerry sell their home in 10 years, they'll have to pay $240,000 — not the initial $120,000 —to get rid of the reverse mortgage.

Of course, their $400,000 home probably will increase in value. But if there's a real estate crash and it's worth only $225,000 in 2013, that's all they have to pay back.

CHIP guarantees the amount owed on a reverse mortgage will never exceed the fair-market value of the home. That's why it lends conservatively, advancing just 10 to 40 per cent of the home's value.

Jean and Jerry may be lucky enough to live to age 90 and 92 in their own house. If they die 20 years after taking out the CHIP reverse mortgage, they will owe $480,000 (assuming a constant 7.25 per cent interest rate).

This means there will be little, if any, money for the children and grandchildren after the house is sold unless the couple has other assets in their estate.

Jean and Jerry don't care about providing for survivors They want more money to spend while they're alive. But there's another risk they face.

What if they don't stay in their home until they die? If they buy another house, they may be able to take the mortgage with them. It's more likely they’ll move into a long-term care facility or a rental apartment.

Since the reverse mortgage is designed to last until they die, Jean and Jerry will have to pay a penalty to get out.

They'll face a penalty of six to eight months' interest — which could be in the $5,000 range — if they decide to sell within the first three years. Afterward, they'll face an interest-rate differential penalty.

About half the people who take out a reverse mortgage choose to get out early, says CHIP senior vice-president Sian Owen. They usually leave the program after five to seven years, moving across the country to be with their children or going into a long-term care facility. In such a case, the penalty is in the $500 range.

There's a larger cost, however — the lack of flexibility for seniors who need to tap their home equity for unforeseen expenses.

Suppose Jean and Jerry use their $120,000 windfall to boost their lifestyle. They can't resist the temptation to visit faraway places and leave the harsh winters in Canada. Before they know it the money is gone.

But as they get older, their health starts declining. They may have to hire a live-in caregiver or renovate the house to make it wheelchair-accessible. Where does the money come from to pay their medical bills?

Sure, they can sell the house. But their debt will have grown substantially — and what they get after discharging the mortgage maybe too little to meet their needs.

Few seniors want to encumber their houses once they understand how CHIP really works. The company has only 5,600 clients, despite the constant advertising and a history of lending since 1986. Owen explains. "Our advertising encourages self-education. If people are asking questions, that's what we consider to be our success."

Unfortunately, most don't get to read the small print until they sign up for a reverse mortgage. CHIP's 17 page legal document, sent to me by a reader, lays out a lot of information that's not included in the ads or at its Web site (www.chip.ca)

For example, you can't rent out all or part of the house without written consent — and only for six months within any 12-month period. You must hire a licensed property manager and provide copies of all contracts and agreements if requested.

CHIP's legal document will be more accessible once translated into plain English, Owen says. Let's hope that happens soon, since more transparency is needed for a company whose goal is education.

Ellen Roseman's Money 201 column appears Sunday. You can reach her by writing Business, The Toronto Star, One Yonge St., Toronto M5E 1E6 or at 416-865-3630 by fax or at erosema@thestar.ca by e-mail.