A Reverse Mortgage Loan (RML) can provide a useful income stream for senior citizens during their retirement. You can monetize your residential property and generate income while continuing to retain the ownership so long as you are alive. I have discussed Reverse Mortgage loans in detail in another post. In this post, I will look at the aspects that you must consider while finalizing a Reverse Mortgage Loan product. I will consider Reverse Mortgage Loan Product from State Bank of India for illustrations.
SBI Reverse Mortgage Loan: Eligibility and Features
- Loan Tenure: 10-15 years (even though regulations allow a maximum tenure of 20 years)
- Minimum Age: 60 years in case of a single borrower.
- Joint borrowing with spouse is permitted. However, one of the applicants should be 60 while the spouse’s age should not be less than 58 years.
- The borrowers must stay in that residential property. You can’t take out a reverse mortgage loan on a let-out property.
- Loan Amount: Rs 3 lacs to Rs 1 crore
How Do Reverse Mortgage Loans Work?
Reverse Mortgage Loans work in a very different way as compared to other loans. Under other variants of loans, you get a lumpsum amount from the bank and you pay the EMI to repay your loan over the loan tenure. In case of reverse mortgage loans, you do not pay any EMI to the bank. Instead, the bank pays you the EMI every month for a fixed number of years. Or rather the bank disburses the loan in monthly instalments over a fixed period.
Why does the bank do that? Well, it gets your house when you are not around. Essentially, after your demise, the bank gets possession of your house. It can sell the house to recover the amount paid to you. Any excess realized amount will be given to your nominee/legal heir. Please understand that even though the bank makes the payment for a fixed number of years, it does not get your house at the end of the fixed period. At the end of the fixed period, the bank simply stops making the payment. However, you can continue to live in the house so long as you are alive. The bank cannot force you to move out. You do not have to pay anything (ever) to the bank under this arrangement.
What Are the Interest Rates and Loan Tenure?
We discussed in the previous section that the bank makes the payment to the owner for a certain number of years. As per SBI website, the loan is given at 10% p.a. to SBI pensioners and at 11% to others. What does this mean?
Let’s assume you take a loan for 15 years. And the loan amount is Rs 50 lacs. With these assumptions, the bank will make a monthly payment of Rs 10,996 for 15 years. How do you calculate this monthly payment? Well, all this means is that: If you invest Rs 10,996 per month for 15 years and earn a return of 11% p.a., you will end up with Rs 50 lacs.
To calculate the monthly payment amount, you can use this excel formula,
PMT(interest rate/12, no. of years of payment*12, 0, Loan amount, 0)
PMT(11%/12, 15*12, 0, 50,00,000, 0) = Rs 10,996
You can consider reverse mortgage arrangement as an investment by the bank to purchase your house. Alternatively, you can think of RML arrangement as a loan where disbursement is done on a monthly basis. However, the bank does not get your house after the expiry of payment period (15 years in this example). It gets the house only after all the co-borrowers pass away. Therefore, you must understand the risk that the bank is taking.
Let’s look at the monthly payments for other values of loan amount, interest rate and payment tenure.
|Monthly Payments||Loan Amount: 50 lacs||Loan Amount: 75 lacs|
|Payment Tenure||Interest Rate||Interest Rate|
|10 years||₹ 24,409||₹ 23,042||₹ 36,613||₹ 34,563|
|15 years||₹ 12,064||₹ 10,997||₹ 18,095||₹ 16,495|
Your Monthly Income Goes up As
- The interest rate goes down
- The payment tenure goes down
- The loan amount goes up, which in turn will go up when:
- The margin goes down (discussed in the next section)
- The market value of your residential property goes up (discussed in the next section)
How Is the Loan Amount Determined?
The loan amount (or so the nomenclature goes) depends on the market value of your property and the margin that the bank employs for the loan. The margin may depend on the condition and location of the property and the age of the borrower.
In case of other loans, a higher margin simply implies that you have to fund a certain portion of the asset price from own pocket. Nothing else changes. In reverse mortgage loans, margin is a big issue. Under an RML arrangement, a higher margin effectively reduces your monthly payments.
Let’s consider a house with market price of Rs 1 crore.
- A margin of 20% means a loan amount of Rs 80 lacs. At 11% and payment tenure of 15 years, you will get a monthly income of Rs 17,594 for 15 years.
- A margin of 25% means a loan amount of Rs 75 lacs. At 11% and payment tenure of 15 years, you will get a monthly income of Rs 16,494 for 15 years.
In both the cases, at the end of 15 years, the bank will stop the payment and will get the house after your demise. Just that, in a higher margin case, you get a lower monthly payment. Clearly, lower the margin, the better it is for you. A higher margin (or a lower valuation) is a way for the bank to reduce its risk and lower the payments. Therefore, a bank would always want to have a higher margin.
Can I Prepay the Loan?
Yes, you can prepay the loan whenever you want. However, what does prepayment mean in this case? Let’s consider an example. You take a reverse mortgage loan of Rs 50 lacs at 11% for 15 years. The bank is obligated to pay you Rs 10,997 per month for 15 years. After 8 years, you want to prepay the loan. You would have received a sum totaling Rs 10,55,712 by then. How much will you have to prepay? You will have to prepay the amount that Rs 10,997 would have to grown to at 11% p.a. in 8 years.
FV(11%/12, 8*12, 10,997,0,0) = Rs 16.8 lacs
Points to Note
- Any payments received under Reverse Mortgage loan scheme are exempt from income tax under Section 10(43) of the Income Tax Act.
- The bank makes the payment for only the fixed period (say up to 15 or 20 years). What will you do after that?
- There will be ancillary charges for processing fee, valuation etc. For instance, SBI charges 0.5% plus taxes as processing fee.
- Since the monthly payments from the bank depend on the market price of the property, the valuation can be a tricky exercise.
- The bank will mandate property insurance to safeguard its interest. That will be an additional pay out too.
- You are required to stay in that house. If you do not stay in the house for a continuous period of 1 year, the bank may recall the facility.
Should You Sell the House Instead?
Even though the sale of house can sometimes be an emotional decision, you must appreciate that a reverse mortgage loan may not really be advantageous to you (assuming there is no emotional value attached to the house). You may be better off selling the house (shift to a smaller house or to a cheaper and peaceful city or stay on rent) and generate income from the proceeds.
For instance, let’s say the market price of the property is Rs 1 crore. At a margin of 20%, the loan amount will be Rs 80 lacs. At 11% and payment term of 15 years, you will get a monthly amount of Rs 17,594 for 15 years. That means bank will pay you a total of Rs 31.66 lacs over the next 15 years and get control of house that is worth Rs 1 crore today. Bad, isn’t? However, from the bank’s perspective, we must appreciate that the bank does not get the house after 15 years.
You could have simply sold the house for Rs 1 crore. Purchase an annuity for life for Rs 50 lacs. At 6% annuity rate, you will get pre-tax income of Rs 25,000 per month for life (and not just 15 years). To find out more about various annuity options and how annuity plans work, you can read about an annuity plan LIC Jeevan Akshay VI. For the remaining Rs 50 lacs (assuming no taxes), you can purchase a smaller house in the same city or a different city. Or perhaps even the same-sized house in a cheaper city. You can also decide to stay on rent.
I do realize it is easier said than done. And it is not all about numbers and optimization. Food for thought, nonetheless.