26 Giffard Street
Williamstown 3016
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Email. reidcont@tpg.com.au
ABN: 65 111 801 079
www.reidconsultants.com.au

1st July 2007

This newsletter is the second in a series to look at options for seniors whose wealth resides in their own home. Previous newsletters discuss what a reverse mortgage is (Jan ’06), the uses of a reverse mortgage (Jul ’06) and comparing taking a reverse mortgage to downsizing (Jun ’07). An option that has been given some publicity recently, usually by financial planners, is establishing a Line Of Credit (LOC) facility with a lender (perhaps before retirement or after retirement using a low-doc or no-doc loan) and investing the money to earn a return to supplement your pension or other income.

The two key questions that need to be answered are:

1. Can it work? The simple answer is - Yes it can, with some heavy proviso’s.
2. Is it for everyone? No it is not.

It is possible to set up a LOC facility before or after you retire based on the equity you have in your property. A LOC is almost like an overdraft or a large credit card, a limit is set that you can borrow and interest is charged on the amount you use or have outstanding. You can repay the full amount used or you can pay a portion. For most people, they arrange the LOC facility so that the interest charged is simply added onto the outstanding amount and the overall outstanding loan balance increases. In this sense, it is similar to a reverse mortgage with the exception that eventually the lender wants to be repaid without the protection offered by most reverse mortgage loans.

What are the differences?These can be grouped in two categories, the amount you can borrow with or without various protections and the risk and return of investing.

1. How much can you borrow?

As you can see, the amount you can borrow is significantly different. The reverse mortgage product is specifically designed that in normal property cycles, equity is retained in the property over normal life expectancy. With lenders who are members of SEQUAL (see our Links page), they subscribe to a code of conduct which includes a ‘no negative equity’ guarantee, meaning that the loan amount will never be more than the value of the property. This is an important protection for seniors and as the reverse mortgage product requires no repayments until death, permanently moved or sale of property, a lender will not chase or foreclose if you do not repay within a time frame as a normal loan requires.

With more competition in this market, many of the reverse mortgage lenders offer a lump sum facility, a cash reserve and an ‘income’ stream or a combination. If the need is to supplement a fortnightly pension, then an ‘income’ stream option is available. For a 65 year old with a $350,000 property, an income stream of $583 per month is possible. This is on top of any existing pension or income stream and is generally not assessable for the government aged pension income test.

With an underlying property growth a 5% per annum, the above graph shows that the loan increases over time to be $270k in 20 years due to interest capitalisation (not repaying interest which is added back onto the loan) yet the property value increases to $950k, meaning that the ‘equity’ you have increases to $680k in that 20 years. In this example, even with a 0% property growth for 20 years, you would still retain equity in your property.

A LOC facility up to 80% loan to value may be possible depending on your circumstances. Generally a LOC facility will have a lower interest rate, a $250k LOC will range from 7.37% or so up to 8.7% for a low doc LOC. (a reverse mortgage ranges from 8.2% to 9.07% depending on the lender). This means you can borrow a far larger sum at a better rate, but there is a requirement to repay the loan eventually or at least repay the amount to keep the facility within its limit set.

There is no protection if the value of the property drops (as happened in some of the Sydney market recently), the lender may enforce you to bring your facility back into line. In a worst case, a lender may foreclose, forcing sale of your property and in these cases, you may not receive anything.

You could set up a LOC facility and use it to draw down $583 per month as the case above with the same effect, however most lenders specifically state that their LOC facility is not to be used as a reverse mortgage facility. The concept that some financial planners have suggested is to draw down a large lump sum and invest those funds. This is a very different use and effect.

2. The risk and return of investing.
In my Oct ’06 and Nov ’06 newsletters I discussed investment strategies and touched on risk and return. As a general concept, the market only offers higher returns for higher risk. Money sitting in a cash management account should be almost ‘risk free’, so an interest rate of 5 to 6% is available. This is normally in the range of 1 to 2% above the underlying inflation rate. As your choice of asset allocation moves to the assets offering higher returns, such as the share market with average returns in the 6 to 8% range above inflation, the risk also increases. On average, you can expect a negativereturn every 4.3 years. We had a period in the 2001 to 2003 period of consistent negative returns in the Australian share market, since then it has performed strongly.

If we review the graph above, which compares the Australian ASX 200 (a broad index - AXJO) to the US NASDAQ (IXIC), you get an idea of the inherent volatility or changes up and down of these markets. The US market has been far more volatile recently than the Australian market and you will also notice that Australia tends to be a follower of US trends.

If we use the same example as above, a house worth $350k, the owner, on advice from a financial planner, borrows $270,000 (77%) and invests it in the Australian share market. As you can see from the graph below, the house price rises as above to be worth $950k and the LOC remains at $270k (presuming interest is paid every month). At the end of 20 years, the effect is the same as for a reverse mortgage as shown above, your net equity after 20 years is $680k.

The interesting part is what happens to the investment. There are many variables to consider and for this illustration, I will ignore income tax issues, pension entitlement issues under the income or assets test, capital gains tax etc. The basic scenario is that you invest the LOC funds of $270k, the return needs to pay the interest on the LOC each month and pay you an amount equal to that of a reverse mortgage (as above) of $583 per month. The dividend return is assumed to be 3% per annum. Any surplus is simply reinvested. The LOC interest rate used is 8% pa being a variable rate only where a reverse mortgage can have a fixed rate for life.

Shown below is a simple table showing the effects of different capital growth rates on the investment and what the remaining balance would be after 20 years for these differing capital growth rates. The graph shows the investment balance when we use real returns, being the Australian All Ordinaries over the last 10 years on a monthly basis, from June 1997 to June 2007.

This table shows a simple percentage growth per annum with no variation. Care needs to be taken with simple analysis like this so the returns shown are not over optimistic.

Using real data, the investment balance would be $244k today

The returns I have used are gross returns, being gross of management fees (1.5 to 3%), financial planner commissions (3 to 5%) etc, so if these are considerable, look at the lower end of growth rates.

As the example shows, it can work. The issue is the risk involved for the benefit. Most will have read of the recent collapses of three property investment schemes, Westpoint, Fincorp and Australian Capital Reserve. These have been schemes which many retirees have invested in and unfortunately lost money. If they had used a LOC facility as described above, not only have they lost their additional income, they risk losing their own home as they can no longer repay the LOC.

If you have a relationship with a very experience financial planner and they can and do generate returns for you and you are comfortable with the risk, it can work well. If you are an astute personal investor, again it can be a worthwhile strategy. If neither applies, give serious thought to whether this type of strategy suits your needs compared to a reverse mortgage.

Mortgage brokers get paid by the lender, it is not money out of your pocket. You get the same rates that a mortgage broker will, it is about time, knowledge and convenience. A financial planner gets paid out of your money, it is a direct deduction from your earnings. That cost may be very beneficial as there are many very competent financial planners around and the returns they do generate far outweigh that cost. Unfortunately there are also some very average planners and some who seem to be commission driven rather than client focused. You need to take account of what is offered from whom before you make this type of significant financial decision.

Give me a call to find out whether either strategy will work for you and what you could borrow based on available cash flow and value of your property. We do not provide financial product advice. We will work with your accountant or advisor to structure a solution that suits your needs and circumstances. We take the approach of looking at your long term goals and working to find a solution through finance for you. This appointment is no-cost and is obligation free, call – 03 9397 7275