How reverse mortgage works

Mr Patil has retired after what can be called a very fulfilling career with a leading engineering company. His only daughter is married and well settled in Bangalore. He owns a large house in Thane -- worth about Rs 80 lakh (Rs 8 million), but he has limited savings (including PPF and EPF) of Rs 10 lakh (Rs 1 million) to generate any major income.

He is not expecting any pension either. His worry now is to pay for his modest monthly expenses of Rs 20,000. His financial assets can at best generate Rs 10,000 per month for him and the income thus generated will not keep pace with inflation -- meaning that after five years, when he will require Rs 30,000 per month, while his financial assets will still generate only Rs 10,000 per month.

The only option he had earlier was to rent his house and move to a smaller house himself or to sell his house altogether and invest the proceeds to earn a higher monthly income. Either way, in his old age, he will be forced to look around for accommodation and keep on worrying about the rising rents -- not a very happy prospect.

This is where reverse mortgage can be of great value.

Budget 2007 amongst other things has given a green signal to the launch of Reverse Mortgage -- a widely used instrument in the developed world by the elderly to derive cashflows from their owned house.

The popularity of the instrument lies in that it converts an illiquid asset -- the house -- into liquid cash flows for the owner, typically a senior citizen. A more attractive feature is that senior citizens can continue to live in that house even after drawing cash-flows from it.

Here is how it works. Reverse mortgage as its name indicates operates in a manner opposite to that of the typical mortgage such as a home loan. In a typical mortgage, you borrow money in lump-sum right at the beginning and then pay it back over a period of time. In your payback -- the EMI -- a portion goes towards paying the interest and the remaining goes towards paying back principal.

All along, you pledge the asset -- namely the home you have bought with the loan -- to the bank. This asset is the security against which the bank is lending to you. In reverse mortgage, you pledge a property you already own (with no existing loan outstanding against it). The bank in turn gives you a series of cash-flows for a fixed tenure. These can be thought of as reverse EMIs.

There are various forms of reverse mortgage available in the developed countries. The specific format National Housing Board (the facilitator for housing finance in India) is promoting is one in which the tenure is 15 years and the owner of the house and his/her spouse continue to live in the house till their death -- which can occur later than the tenure of the reverse mortgage.

Simply put, in case of Mr and Mrs Patil, if they were to opt for reverse mortgage for tenure of 15 years, they will get annuity (the reverse EMI) from bank for 15 years. After that, the annuity payments stop.

However, they continue to live in the house. Assume that Mr Patil dies after 17 years. Mrs Patil can still live in the house till she is alive. After her death, the bank will give their heirs two options -- settle the overall outstanding loan and retain the house or the bank will sell the house, use the proceeds to settle the outstanding loan and give the rest to the heirs.

The bank bears the risk that the outstanding will exceed the market value of property then and will not ask for the difference from the heirs.

The key question is -- how much of an annuity income can my house generate using reverse mortgage? The banks have so far not indicated which interest rates they will use to determine the EMI -- however, we can safely assume that it will not exceed the interest rates used for loan against property -- which is currently in the region of 12-14%.

Second important variable is the loan to value ratio. Most loans against property work at 60% loan to value ratio -- i.e. by pledging a Rs 1 crore (Rs 10 million) property, you can get a Rs 60 lakh (Rs 6 million) loan. Some banks are however designing reverse mortgage products with a higher loan to value ratio -- as much as 90% in some cases.

The specific annuity paid out also depends on the age of the home owner. Higher the age, higher the annuity everything else being constant. For simplicity consider a 60-year-old home owner taking reverse mortgage with loan to value ratio of 80% and an interest rate of 12%.

The annuity from reverse mortgage works out to be roughly ~Rs 160 per lakh of property value. Hence for Mr Patil, with a property valued at Rs 80 lakh, the annuity he can expect will be in the range of Rs 12,800 per month.

Coupled with his income from financial assets, he can continue to live comfortably with no cutback on lifestyle.

The author is Director, PARK Financial Advisors Pvt Ltd, Mumbai. He is an IIM-Ahmedabad alumnus. He can be contacted at info@parkfa.com