Kapadia LLP CPAs

If Canadians have the feeling that they are being squeezed from all sides when it comes to household finances, it’s because they are. In 2022 Canadian consumers have been hit by a double whammy of three successive interest rate hikes since March (with more increases almost certainly on the horizon) while dealing at the same time with increases in the cost of everyday goods to an extent that has not been seen, in some cases, for as much as forty years.

Adding to the misery, price increases caused by inflation are disproportionately affecting goods which are simply not discretionary expenditures. In May 2022, while the overall rate of inflation was 7.7%, the cost of groceries rose by 9.7%, with increases recorded across nearly all food categories.  

No one feels the impact of rising prices as much as those who are living on a fixed income. And, while such individuals and families can be found in all age groups, retirees make up the largest Canadian demographic who live on such fixed incomes.

Those retirees also, unfortunately, have had to content with a third financial factor in 2022. For the majority of retirees who do not receive a pension from a former employer, savings accumulated in a registered retirement savings plan or a registered retirement income fund provide, along with government programs like the Canada Pension Plan and Old Age Security, the bulk of retirement income. For the past several years, interest rates have been so low that, in order to generate sufficient returns to provide that retirement income, retirees have had to move away from the safety of traditional investments like guaranteed investment certificates and into more risky investments, usually in mutual funds. And, as of the end of June 2022, the market value of such funds on the Toronto Stock Exchange is down significantly from the start of the year. Consequently, retirees who might otherwise consider selling investments in order to generate needed cash flow may well hesitate to do so when such investments have dropped significantly in value.

It must seem to Canadian retirees that there are no good options when it comes to generating the cash flow needed to meet this perfect storm of bad financial circumstances. Fortunately, however, the 68% of Canadians over the age of 65 who own their own homes (based on Statistics Canada’s figures for 2016), do have options. While real estate prices in many areas have softened somewhat over the past couple of months, Canadians who are now of retirement age and own their homes most likely purchased those homes many years or even decades ago and have, consequently, built up significant equity. And that equity can now provide a source of retirement income.

For such retirees who want to remain in their homes there are essentially two options. The first is a home equity line of credit, the second a reverse mortgage.

The home equity line of credit (or HELOC), as the name implies, is a line of credit which permits the homeowner to borrow up to a pre-set limit, based on the current market value of their home. Such borrowings can be in any amount (up to, of course, the limit on the HELOC) and can be made at any time and for any purpose. Typically, the interest rate charged on a HELOC is a variable rate – usually one half or one percent more than the prime rate used by the lender. There is, however, a significant feature of the HELOC of which potential borrowers must be aware. While there is generally no obligation to repay amounts borrowed from a HELOC until either the death of the homeowner or until the house is sold, borrowers are required to pay interest each month on the total amount borrowed.

Take, for example, a couple who own a house currently valued at $750,000. Assume that the couple obtain a HELOC based on that home value and borrow $1,000 each month ($12,000 annually), from the HELOC to help meet current cash flow shortfalls. At an interest rate of 4.70%, they will be obliged to make an interest payment of approximately $50 per month on that $12,000 borrowing. As the amount of HELOC indebtedness increases over time, or the interest rate charged goes up, the amount of those required monthly interest payment obligations will, of course, also increase.

The other option open to homeowners to provide cash flow is a reverse mortgage. Like the HELOC, a reverse mortgage allows homeowners to borrow based on the market value of the property. A reverse mortgage is also similar to a HELOC, in that borrowers can borrow a lump sum amount, or can opt to structure the reverse mortgage as a series of payments which will provide a regular income stream, or some combination of the two. And, as with a HELOC, no repayment of the funds advanced under a reverse mortgage is required until the death of the homeowner, or until he or she leaves or sells the home.

The basic advantage of a reverse mortgage over a HELOC is that no payments of interest are required under a reverse mortgage. However, homeowners need to consider the impact that advantage can have over time. Once the reverse mortgage is taken out, interest will, of course, be levied on all amounts provided, and will accumulate from the time the funds are first advanced. Total interest costs can add up very quickly and reach significant amounts by the time the debt is eventually to be repaid, usually out of the proceeds from the sale of the house. And, of course, every dollar of funds advanced and interest levied eats away at the amount of equity which the homeowner has built up, on a dollar-for-dollar basis. By contrast, with a HELOC, where accrued interest charges must be paid monthly, the amount of debt (and consequent reduction in equity) will never be greater than the principal amount borrowed. Finally, under the terms of many reverse mortgages, a prepayment penalty is levied where the homeowner moves or sells the house within a few years of obtaining the reverse mortgage – the exact time frame will depend on terms provided by the particular lender. With a HELOC, however, repayment of the outstanding balance can be made in part or in full at any time, without penalty.

As is almost always the case with financial issues, there is no one right answer or even a one-size-fits-all answer, as the “correct” answer is always based on the particular financial and life circumstances of the individuals involved. Some help with making a decision on whether a HELOC or a reverse mortgage makes sense in one’s circumstances can be found on the website of the Financial Consumer Agency of Canada at https://www.canada.ca/en/financial-consumer-agency/services/mortgages/borrow-home-equity.html, where the benefits and downsides of each option are outlined in detail.

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The information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice. Please contact our office for more information on this subject and how it pertains to your specific tax or financial situation.