How do equity release schemes work?

The generation of baby boomers, people who are currently between 52 and 70 years old, is retiring. In the UK, this generation has benefited from free higher education, final salary pensions and, most crucially, exponentially accelerating house prices.

But while this is more than following generations can ever hope to enjoy, baby boomers are not equally affluent, and many pensioners fall into the 'asset-rich but cash-poor' category.

Their homes have become the main repository for many people's wealth, and it is no surprise that there is growing demand for ways to convert bricks into cash.

Could housing wealth be a sustainable source of retirement income?

EQUITY RELEASE OPTIONS

Equity release schemes offer two main ways to access the equity in your house. The first option is a home reversion plan; the second is a lifetime mortgage.

With a home reversion scheme, you sell all or part of your property at less than its market value (usually 20-60 per cent of market value) in return for a tax-free lump sum, a regular income or both.

You can then live in the home as a tenant, but without paying rent. Home reversions constituted just 4 per cent of the equity release market over the past 25 years, according to the Equity Release Council (ERC).

By far the most equity release lending has been via lifetime mortgages, which tend to offer much better value for money than home reversion schemes. These are designed for people over the age of 55. As the name implies, these mortgages last for life.

The maximum loan-to-value ratio depends on the borrower's age, but it can be as high as half the value of the house for those over 80.

The interest on the loan rolls up - so interest accumulates on interest added to the loan - but no loan repayments are due until the borrower dies or moves into long-term care.

These products could suit someone who is short of money in retirement, says Bernie Hickman, managing director at Legal & General Individual Retirement. However, anyone interested in a lifetime mortgage should take professional advice and understand the implications of taking one out.

According to the ERC, lending figures grew by 21 per cent in the second half of 2015. But equity release is still a small fraction of the mortgage market: in 2015 £1.6 billion worth of lifetime mortgage loans were made, compared with £220 billion in the mortgage market as a whole.

LIFETIME MORTGAGES

There is increasing demand for these schemes, but it is important to consider them with your eyes open to the risks they entail.

The average house value of those applying for lifetime mortgages was £264,397 in 2015, according to the ERC, the loan-to-value average was 30.8 per cent and the average sum taken out was £81,324.

About 60 per cent of people opt for regular income payments, while the remaining 40 per cent choose to take out a lump sum.

On average, people are charged 6.2 per cent interest on their loan annually, though since the turn of the year, some lenders have introduced interest rates of less than 5 per cent. A typical loan can double in size about every 10 years as the interest compounds.

Lenders and advisers credit the ERC with making the equity release market safer for consumers.

Most lenders subscribe to the council's principles: interest rates must be either fixed or, if variable, capped for the life of the loan; customers must be allowed to transfer the lifetime mortgage contract to an alternative property without incurring an increase in the interest rate; lifetime mortgages must have a 'no negative equity guarantee', so that the loan can never exceed the net proceeds from the sale of the house.

All potential customers are required to get professional financial advice and consult an independent solicitor.

Despite the flexibility and 'security' provided by equity release, it still has to be considered a last resort, says Simon Webster, managing director at Facts & Figures: Chartered Financial Planners, because compound interest builds up and makes it expensive.

He adds: 'Albert Einstein said compound interest is the greatest force in the universe, and compounding is the problem. If you live a long time, your initial loan will grow into a much larger one. If house prices fall, you can end up with no equity in your house.'

CAN EQUITY RELEASE PROVIDE A COMROFTABLE RETIREMENT?

Webster says people choose to take out a lifetime mortgage 'because they need the money'.

He adds that equity release is a value judgement: 'The value of equity release to someone who hasn't got any money is a lot higher than it is to someone who's sitting comfortably in an ivory tower in London making the regulations up. People have got to eat, and they can't eat bricks.'

That said, equity release can also be used to maintain a comfortable lifestyle.

The certainty of an additional guaranteed monthly income stream gives peace of mind, and it can be the difference between an austere retirement and a comfortable one, says David Finan, chartered financial planner and managing director at independent financial advisers Jardine Finan.

He adds: 'Alternatively, there is the option to choose a lump-sum payment, which could be used for home repairs or a new car.'

Mark Lambert, principal at Viva Retirement Solutions, says: 'You don't need to take a big lump sum at the beginning, as this could be costly in the long run and offer poor value for money over the short term.'

'Instead, the plan can be set up with a much smaller initial release to fund immediate requirements, and subsequent access as required to a pre-agreed amount held in reserve by the lender.'

Lambert says an increasingly common reason for releasing equity from a property with a lifetime mortgage is to repay an existing interest-only mortgage that has come to the end of its term.

The ERC cites the example of Mr Reay, who was forced to reapply for a mortgage on his home in Northumberland following his divorce. His mortgage was due to come to an end, and because he was aged 71, he was unable to extend the term.

He needed £85,000 to clear the outstanding mortgage on his property valued at £220,000. Otherwise, he would have to move. A lifetime mortgage came to his rescue.

Recently, however, banks such as Halifax and Nationwide have raised the age limit on mortgages to 80 and 85 respectively, making these cheaper alternatives to equity release for those who can afford to pay the monthly interest.

All the advisers we spoke to recommended that those considering equity release who have children should talk to them about their plan.

'Any family members expecting a legacy should be made aware that you have undertaken equity release and will therefore be leaving a smaller legacy,' says Finan.

PITFALLS AND PENALTIES

Exit penalties can become a problem. Webster points out that if someone's financial situation changes - because of an inheritance or a lottery win, for example - and they decide they want to pay off their loan, they can find that the early redemption penalty makes this too expensive.

Lambert echoes this point and adds that penalties can be as high as 25 per cent of the equity released.

He adds: 'If repaying the lifetime mortgage loan is something you know at the start could feasibly happen, plans can be recommended that will help ensure penalties are kept to a minimum.'

Another pitfall, according to Finan, is that if someone is in receipt of means-tested state benefits, a lifetime mortgage may result in the loss of those benefits, because the cash released is treated as savings.

Ultimately, equity release should be a fall-back position, says Adrian Walker, retirement planning expert at Old Mutual Wealth. Before committing to a lifetime mortgage, people should consider downsizing and other alternatives.

The problem, he adds, is that most advisers are only qualified to give advice on mortgages, equity release or investments, when what people considering equity release need is an awareness of the bigger picture to make the most of their options.

Those who do decide to take out a lifetime mortgage need to consider a range of factors.

YOUR EQUITY RELEASE CHECKLIST

Adrian Walker, retirement planning expert at Old Mutual Wealth, suggests considering the following questions before signing up for equity release:

• As an alternative to equity release, could I borrow the capital required under normal lending terms, and if so at what rate?
• Could I meet the interest payments from existing income?
• Could I arrange other assets more tax-efficiently to produce more income for my needs?
• Would a lender allow me to convert a normal loan to equity release at a later date? If so, what would the terms/costs be?
• Could I reinvest capital released to provide greater income after tax than I'd get through income options under equity release?
• If I use equity release, what will happen to the property ownership if the amount owed equals or exceeds the property's value?
• Am I going to discuss this with other family members before I make a decision?
• Should I arrange for a power of attorney to be put in place?
• Do I have any insurance in place that would provide a legacy in the event of my death?

HOW A LOAN FROM YOUR HOME MIGHT WORK

Bernie Hickman, managing director at Legal & General, gives an example using L&G terms and rates. Someone aged 71 with a house worth £278,000 was recently able to borrow £75,000 at a 4.99 per cent annual fixed rate.

If they live to the age of 89 or move into long-term care at that point, the debt, including interest, will have grown to £180,000 over 18 years.

But if the property's value keeps increasing at 4 per cent a year, the house's value will have grown to £563,000 during that time, leaving £383,000 of equity in the house after the debt is settled.

• A 70-year-old person can get a maximum of 40.5 per cent of their house value as a loan. Those aged 84 and over can get up to 55.5 per cent.
• The minimum house value is £100,000, and the minimum loan is £10,000.