How reverse mortgages work

Step 1: See if you are eligible

You will generally have to be at least 60 to qualify for a reverse mortgage, and some lenders insist you be 65 or over. You may also need to have paid off your mortgage in full, depending on the lender.

Step 2: Find out how much you can borrow

If you are 60, the most you can usually borrow is 15-20 per cent of the value of your home. As you get older, the amount you can borrow increases – generally it's 1 per cent for each year over 60. If you are 65, for example, you should be able to borrow 20-25 per cent of the value of your home.

Step 3: Work out how much your loan is going to cost

Because key factors including interest rates and the amount you draw down are likely to change, you won't be able to work out exactly what your loan will cost. You will also need to include any fees attached to setting up and continuing to operate the mortgage.

However, there are reverse mortgage calculators available online, such as the one provided by ASIC's Moneysmart. By law, a lender must also show you projections of how the loan could affect your home equity before you sign, that will give you a good indication of how much you will owe your lender when the time comes for your home to be sold.

You will need to be 60 or over and own your own home to take out a reverse mortgage.

Most of the big banks have stopped offering new reverse mortgages. They are now offered mainly by specialist lenders, such as Heartland Bank and Household Capital, and a small number of customer-owned banks.

Because the money you borrow against the value of your home is not considered income by the tax office, you won't pay tax on your reverse mortgage income or withdrawals.

You will have to continue to pay any property rates and taxes while you remain living in your home.

Having a reverse mortgage could affect your government benefits. For example, a lump sum payment could increase your asset balance to the point where you do not qualify for a full age pension.

It's best to check with Centrelink before you apply for a reverse mortgage.

How home loans for pensioners work.

There are a number of alternatives to reverse mortgages that can help you boost your bank balance. These include:

• Downsizing. Selling your home and buying a cheaper property is a straightforward way of freeing up some extra cash.
• Create passive income. Rental income can be created by renting out a spare room to a permanent tenant or via popular short-term rental sites such as Airbnb and Stayz. You could even put a tiny house on your property and rent it out, or convert your garage into a habitable room.
• Home Equity Access Scheme. Another alternative is the government's Home Equity Access Scheme (formerly the Pension Loans Scheme). The government lends you money through Services Australia, as fortnightly payments of up to 1.5 times the maximum pension rate, and you can also take limited lump sum advances. Interest is charged (3.95% p.a. at the time of writing) and the loan is repaid when your home is sold, with a no negative equity guarantee. To be eligible, you or your partner must be Age Pension age (67) and own real estate in Australia you can use as security.

Pros

• Extra cash. Taking out a reverse mortgage means you will have extra money available while still owning, and living in, your own home.
• No restrictions. You can use the money for whatever you like, including funding your retirement, taking a holiday or paying down debt.
• No repayments. You don't have to make repayments if you don't want to.

Cons

• –Higher interest rate. The interest rates and fees on a reverse mortgage are usually much higher than those on a normal home loan.
• –Compound interest can significantly reduce home equity. If you decide not to make repayments on your loan, the effect of compound interest means you may end up owing much more than you expected and you could see the equity in your home greatly reduced. This could affect your ability to pay for aged care and medical expenses when you finally sell your home.
• –Interest rates could rise, property values could fall. Another thing to keep in mind is how interest rates and property prices could affect your home equity. If interest rates increase and/or property prices decrease, you may end up with less money than you hoped for when your home is sold.

Peter, 67, and Jenny, 66, are funding their retirement with superannuation and a partial age pension from Centrelink. They have repaid their mortgage in full and so own their house outright. Although they have enough to live on, they would like to buy a newer car and a caravan to enable them to take a trip around Australia.

They decide to apply for a reverse mortgage. Both of their children are in reasonable financial circumstances, so they are not concerned about depleting their eventual inheritance. Following their application to a specialist reverse mortgage lender, they are invited to meet a broker for discussion and advice.

During the meeting, the broker explains that they can borrow up to 21% of their home's value at a variable interest rate of 9% p.a., following a professional valuation to establish how much it is currently worth. He also itemises the fees they will have to pay – $2,100 to cover the application fee, stamp duty and brokerage.

Using a reverse mortgage calculator, the broker demonstrates the effect on their desired loan amount – an $80,000 lump sum – of compound interest over 20 years (a stage at which they may need to fund aged care), assuming a 3% annual increase in their property value.

Peter and Jenny are reassured to find that, based on their estimate of their home's value at $640,000, they would still have about 57% equity in their home in 20 years' time (a property value of around $1,156,000 and a loan by then of about $493,000 if they make no repayments). That's less than they expected, because at 9% the loan roughly doubles every eight years.

However, the broker then uses the same calculator to show what could happen if the variable interest rate rose to 11%.

In this case their home equity would fall to about 37%, or around $422,000. They are alarmed by the fact that this may not be enough to cover the lump sum entry cost of aged care for both of them. When they make enquiries at Centrelink they also find out that they may lose their partial age pension and attached benefits if they add as much as $80,000 to their total assets other than their home.

As a result, they halve their plan to a $40,000 lump sum, and decide to draw more later only if they need it. The calculator tells them that after 20 years their home equity will be around $903,000 (78%) if interest rates don't change, or about $780,000 (67%) if the rate rises to 11% p.a. They are comfortable with this, and the official valuation of their home comes in higher than they expected at $675,000, which gives them a little more buffer.