denotes premium content | Jan 9 2009 Feature
posted 24 Mar 2005 in Volume 10 Issue 3
Equity release in retirement
As property values escalate, cash-poor clients with valuable properties are increasingly turning to their legal advisers for assistance in unlocking it for personal use. Harvey Cole, ECA’s economics adviser, considers how and if to release home equity in retirement.
It is estimated that people older than 65 own residential property with a value, free of any loan or mortgage, of around £500bn. In fact, many find that while they are comparatively well-off in terms of assets, their income from pensions and other sources leaves them hard-pressed to meet their regular weekly needs.
It is therefore not surprising that recent years have seen a revival of plans enabling them to raise capital or take out a mortgage to provide a lump sum out of which they can finance an improved level of current spending. This follows the period after the crash in housing prices after 1989 when such schemes got a bad name, partly because many of them were operated in the best interests of the providers rather than the clients, but mainly because of the extent to which falling house prices left owners in a state of negative equity (owing more on their home than it was worth).
This time round in the housing boom, there is widespread confidence (as yet to be fully tested) that the spectre of negative equity will not reappear. However, anyone thinking of taking out a scheme for realising part of the capital locked up in their home would do well to look the apparent gift horse firmly in the mouth (and to take professional advice) before making any commitment.
In the past two years, well over £2bn has been ‘invested’ in releasing equity in homes through one of the two main types of scheme offering this facility. These are known as ‘home reversion plans’ and ‘lifetime mortgages’. The former account for about one-quarter of transactions, with the other three-quarters being lifetime schemes. They work in rather different ways, and one immediate point to note is that since October 2004, the mortgage-based plans have been regulated by the Financial Services Authority (FSA), which offers a measure of comfort and protection for borrowers. Reversion schemes were held to be outside the existing remit of the FSA, but under pressure from various consumer interests, legislation is expected to be firmly in place to cover them during 2006.
Home reversion
Reversion plans are normally offered to those who are over 60 and who also own their homes free of any mortgage. The financial institution that provides the fund will purchase a proportion of the house (usually between 25 and 75 per cent – although higher figures can be arranged). However, the price paid will be subject to a discount varying according to the age of the client – the older you are the lower the discount. Typically, a 50 per cent share of a house worth £250,000 would produce around £60,000 for a 70-year-old couple. They would then continue to live in their own home, free of rent and other charges. On death, or in some cases on the owners having to go into permanent care, the house is then sold and the lender takes the same share of the proceeds as was originally advanced. Thus, if the house is sold for £300,000 the lender takes £150,000. The owners’ estate receives £150,000 which, together with the original £60,000, means that they receive 70 per cent of the market value. That is a rather better bargain than it may appear at first, as they will have had the benefit of an interest-free loan of £60,000 for (on average) around 12 years for £90,000.
There is also the incidental advantage that a reversion scheme reduces the value of the eventual estate, thereby reducing any bill for inheritance tax (IHT) but, by the same definition, also cutting amounts available to pass on to relatives and other beneficiaries. On the other hand, it has to be recognised that reversion schemes can greatly limit subsequent options, such as moving to be nearer relatives or downsizing, since penalties may apply for ending the scheme – if indeed that is allowed at all.
Costs of entering into the arrangement have to be considered too. Professional and initial charges, upwards of £1,000, may well be involved quite apart from any structural and other work that may be required by the lender to bring the property to acceptable standards.
Lifetime mortgages
Lifetime mortgages do not involve selling a proportion of a house, but simply borrowing against its value.
The difference between this type of mortgage and conventional loans is that no capital is repaid, and interest is “rolled up” rather than paid monthly or annually and added to the initial advance.
Even though these have come under FSA regulation since October 2004, there are downside points which prospective borrowers should take into account.
First, rates of interest are appreciably higher – around 1.5 to 2 per cent – than normal fixed mortgages. Secondly, re-mortgaging to take account of falls in interest rates is not normally allowed. When Norwich Union cut its charges for new business of this kind from 7.35 to 6.99 per cent, nearly 40,000 existing mortgagors found themselves locked in to the higher rate. Arrangement fees are usually in the range of £500-£600, and valuation and other professional costs must be added.
While it is possible to switch a lifetime mortgage to another provider, or to terminate one early, substantial penalties can be involved – averaging around £2,000 – and in some cases switching has cost almost as much as the original loan. Potentialrestriction on the ability to move is also a factor.
An interesting aspect of lifetime mortgages is that, instead of taking the lump sum at the outset (and paying interest on the full amount for the whole period of the loan), it is possible to use it as a form of annuity and draw fixed amounts annually or monthly. For example, if you had a mortgage of £30,000 and chose to take £150 a month for 200 months (16 years, 8 months) you would pay interest (still rolled up to the eventual sale of the property) on £150 in the first month; £300 in the second right up to £30,000 only in and after the 200th month. At a rate of six per cent, the rolled-up cost on drawing the full £30,000 would be rather over £15,000. While this approach means that there is no chance of earning interest on the £30,000 lump sum as it is being used up, simply rolling up the amount owed in interest (and if this is compounded at monthly intervals rather than annually, the cost soars further) after ten or 11 years deferred interest will start to exceed the amount of the loan.
A real danger is that equity in the property will then be rapidly eroded. On a 50 per cent mortgage, and assuming no growth in house prices, the net value would fall to zero in that time – and even with some appreciation in a period of 20 years, there could be little or nothing to show for the heirs once the mortgage and rolled-up costs have been met.
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New options are also opening up in the form of variations to existing schemes which avoid or reduce some of their snags.
One of which is called a ‘lifetime mortgage’. Additional versions of this are expected to follow the initial launch by Just Retirement. This allows loans to be taken out as and when required, with a minimum of £5,000 at a time. The interest charged on each slice is fixed when the loan is made so that the total of the debt is known in advance, regardless of how long the borrower lives. This avoids the situ-ation where the liability is uncertain, but the downside is a larger initial commitment.
Age Concern has started a modified form of roll-up mortgage. This is aimed primarily at poorer pensioners and offers both a lower threshold for loans (down to £30,000) and concessionary rates of interest. It also offers an option in the form of monthly income payments which are, in effect, a series of fixed loans rather than an annuity. However, it does have the opposite disadvantage to an annuity in that a prolonged retirement could see the flow of payments exhausted within the borrower’s lifetime.
Other solutions: Family to the rescue?
Although equity release schemes appear not to be very good value for money, they do provide a partial solution to a widespread problem. It can be a lot more complicated – and raise a different set of difficulties – to adopt a sort of do-it-yourself approach by, for example, trying to keep it in the family.
Some people have tried to help their parents by buying their home (or a proportion of it) from them so that they can continue to live there. However, this raises the risk of running into serious tax problems. Unless the parents pay a market rent, they will be assessed for income tax on the benefit they enjoy, and if they ‘give’ the house to the children while continuing to live in it, it will not be an effective gift for IHT purposes even if they survive the mandatory seven years. Furthermore, the purchasing children would be acquiring a second property and thus be liable to capital gains tax on any subsequent increase in its value.
Keep it simple
The most effective approach to releasing capital from a home (particularly if, like so many, it is now too large or inconvenient for an elderly couple) is to downsize, moving to a smaller home and realising a lump sum in the process. Apart from the inevitable upheaval, the only real cost is likely to be fees and stamp duty.
For those who do not wish to move from a familiar home and who have sufficient income to meet the interest costs of a new mortgage on an appropriate proportion of their existing house, another alternative is available. Age is no bar to taking out a mortgage if existing income is available to meet the interest on it. At current rates, £10,000 of capital can be raised for approximately £500 a year.
Taking a ten-year view, this means £2 to spend for every £1 in interest and again if it is relevant, there could be a reduction of £4,000 in the eventual IHT bill.
It is certainly a good idea to see if this can be arranged before going on to more expensive and more problematic remedies.
Harvey Cole is ECA’s economic and development consultant. He can be contacted by telephone on 01962 865930 or by writing to the following address:
