This month’s bombshell report about the growing gap between Canadians who retire early and life expectancy suggests further fallout for retirees who rely on home equity loans.
The Manulife survey finds 46 per cent of respondents retired earlier than planned as the number of people who lived to 100 has more than doubled in the past 20 years.
The potential of a 40-year retirement puts an extra financial strain on the millions of retirees who borrow from the equity in their homes. According to Statistics Canada homeowners owed just over $170 billion on Home Equity Lines of Credit (HELOCs) with an average outstanding balance of around $70,000.
As of 2023, Canadians had also accessed over $8.5 billion in reverse mortgages, based on Morningstar DBRS data.
Despite recent interest rate cuts by the Bank of Canada, the posted five-year fixed reverse mortgage rate from Home Equity Bank, the primary provider of reverse mortgages in Canada, is 6.5 per cent compared with just under four per cent for conventional mortgages.
Reverse mortgage rates are normally higher than conventional mortgage rates but due to the nature of reverse mortgages, higher rates eat away at the equity in the home and compound total interest payments over time.
How a reverse mortgage works
Reverse mortgages allow home owners aged 55 and older to borrow tax-free money against up to 55 per cent of the appraised value of their homes. Legal ownership remains with the homeowner but the amount borrowed and accumulated interest must be paid when the property is sold or transferred, or when the homeowner dies.
As the name implies, reverse mortgages are similar to conventional mortgages — but instead of payments flowing into the home, they flow out. That means instead of the principal (amount owing) falling over time, the principal rises over time.
How a HELOC works
A home equity line of credit allows homeowners to borrow against the equity in their homes at will by simply transferring cash when they need it.
Borrowing limits can be up to 80 per cent of the home’s appraised value, minus any outstanding debt on the first mortgage.
The interest rate on HELOCs is usually tied to the prime lending rate at most banks, which is currently about 4.5 per cent. HELOC rates are often up to one per cent above prime, which still makes them lower than a reverse mortgage in most cases.
If the rate is variable, however, the principal will be extra sensitive to interest rate increases. In some cases, a lender will offer fixed-term home equity loans over various periods of time like a conventional mortgage, but HELOC rates remain susceptible to rising interest rates whether the principal grows or not.
Equity will be eaten away at an accelerated pace
In both cases, the need to borrow more over time will compound the total debt burden and eat away at the equity in the home; leaving less when the homeowner moves or passes away.
Home equity will further erode if rates rise and/or the value of the property falls.
Leveraged home owners will suffer in silence
Government and finance industry interests have sounded the alarm on home equity debt levels but stop short of considering it a “systemic risk”, or risk to the entire financial system in the event of mass default.
Banks actually benefit from higher home equity debt levels as long as borrowers have collateral in their homes to cover it.
In fact, when the economy tanks HELOCs save far more people from credit defaults than they cause, which helps stabilize the financial system during crises.
Many older homeowners could feel the squeeze in silence as they sink deeper in debt and watch their home equity erode faster than it appreciates.
Under Canadian law, lenders can not confiscate a home; but as leveraged homeowners require more cash to meet living expenses, and interest payments grow, they could be forced to sell to cover their loan or leave little to no equity for beneficiaries when they die.
