The pros and cons of equity release
Filed under: Mortgages
If you're approaching retirement but don't have a huge pension, you might be worried about your future. But have you thought about your biggest asset: your home?
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If you've paid off your mortgage, your home could provide you with a financial lifeline.
You could sell up and downsize, which could provide you with a pot of cash. Or you could rent out a room, and if you earn £4,250 or less in a year the money's tax free.
If you don't fancy either of those options, there's equity release. This is being increasingly touted as a solution for people who own their home but don't have huge amounts of retirement savings.
What is equity release?
Put simply, equity release is when you use the value of your home to give you an income but you remain living in the property until you die or go into long-term care.
In return, the company giving you the money will either claim your home when you die, or you will repay any money owing if you sell your property and move into care.
There are two main types of equity release plan: a lifetime mortgage and a home reversion plan.
A lifetime mortgage is a loan secured on your home. It's paid to you either as a monthly amount or as a lump sum.
However, you are charged interest on the amount you're borrowing, and this can mount up if you live for a long time after you've taken out the equity release policy. Interest rates on equity release policies are generally much higher than on ordinary residential mortgages.
So, for example, if your home is worth £400,000 and you release a fifth (20%) of its value – £80,000 – at an interest rate of 6% the cost of the lifetime mortgage will add up as follows:
As you can see, it's essentially a reverse mortgage that can wipe out the value your home has gained relatively quickly.
Will the effect of compounding, or interest on interest, ultimately mean the value of the home is less than the lifetime mortgage borrowed against it? If house prices rise, then this shouldn't be an issue, but there is a danger of negative equity.
Many equity release plans allow you to insure yourself against this, so there's no outstanding debts when you die.
Look closely at the total cost if you're considering a lifetime mortgage and not just the interest rate.
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This is where you sell all or part of your home to a company and it leases it back to you to continue living in.
When the property is sold, the reversion company will take the agreed amount. If there is any left, it will paid to the estate.
In this instance, you'll only receive a percentage of the market value of your home as the company may have to wait for years to see its money. Depending on the value of your home, this may not actually make that big a difference to your circumstances.
If you're thinking about signing up for an equity release scheme, do remember that the industry has traditionally had a poor reputation. There was a big mis-selling scandal in the 80s and 90s when commission-hungry advisers pushed people to release equity from their home and then buy investment bonds which later crashed in value.
The industry's reputation has improved in recent years but it's still essential that you use a provider that is affiliated with the Equity Release Council (formerly known as SHIP).
Key things to consider
There are also other important factors you should think about before you sign up for a scheme.
Firstly, consider any bequests you had planned to give to family or friends. You are essentially signing your home away, which means it cannot be passed on as an inheritance and your dependents might not receive anything.
It's important to talk about this with your family, particularly if they were hoping to receive some money from your estate when you die. It could save a lot of heartache later on. I've also read about cases where a child or children would have bought the property from their parent(s) at just under market value, meaning equity release is completely unnecessary.
Another is the effect it may have on any benefits you are claiming, as your income will increase if you receive money from an equity release scheme. Ask for a personal illustration of your circumstances or, if necessary, speak to an independent financial adviser.
You should only borrow as much as you'll need, as otherwise you'll just be wasting money on interest payments.
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