Equity release is becoming increasingly popular, but brokers need to make sure borrowers understand what they are dealing with, say Jackie Bennet and Bob Wright
The fastest growing area of the mortgage market is equity release. An increasing number of people aged 60 and over have an inadequate pension or need a lump sum for some essential or desirable expenditure, which means that using the equity locked up in their home can be an excellent way of generating the cash if other possibilities have been exhausted.
However, more than half of those people who release cash from their homes do so because they wish to generate extra money to spend each month rather than a specific capital requirement. Often they secure this income by releasing equity in the form of a lump sum, which they convert into income by investing in an annuity.
Consequence
Using an annuity funded by equity release is not the best method of generating income for most people. There are a small number of equity release lenders who offer products which allow equity to be drawn down as a monthly amount, which is essentially a series of small loans.
As a consequence the debt is much smaller in the early years, which means that if a borrower dies early the impact on the estate is much less than it would have been if a lump sum had been used to buy an annuity.
In addition, because the debt is accumulating more slowly, the effect of compound interest takes longer to bite into the estate, and so there is an advantage to beneficiaries of the estate which would normally extend well past their life expectancy.
The cost of generating income decreases with age and statistical life expectancy. For example, a 66-year-old single man who paid tax at standard rate and needed a net income of £250 a month would need to pay a leading annuity company a lump sum of £44,058.
However, a man who is five years older would only have to pay £39,702, and ten years older, £32,019. Meanwhile, a woman of the same age, or a couple wanting the annuity to be paid until the second death, would pay significantly more to reflect their longer life expectancy.
However, if the 66-year-old man previously mentioned took his £250 a month as a series of equity release drawdowns using a leading lender, his beneficiaries would still be more than £40,000 better off when he was aged 90 - a period of 24 years. The advantages to women, couples and all those paying a higher rate of tax are greater still.
If equity release is being considered to generate extra spending money the monthly drawdown product is well worth considering. However, any equity release option is a big decision and one where professional advice is strongly recommended.
The number of borrowers taking out equity release mortgages grew strongly last year and is expected to increase further. In recent years rapidly rising house prices have produced a significant increase in the wealth that people hold in property. It is now estimated that people aged 65 or over may now hold as much as £460bn worth of unmortgaged equity in their homes.
Strong growth
At the same time, the combination of an ageing population in the UK and the impact of poor stock market performance on pension funds have fuelled concerns about the ability of people to support themselves in retirement.
Drawing on the wealth they have built up in property could help older people make up a pension shortfall and lifetime mortgages can provide the key to unlocking that wealth.
So why choose equity release? As well as topping up modest pension income, older people can use the wealth they have built up in property in a variety of ways - to pay for medical care, repairs or improvements to their home, or to enhance their lifestyle in other ways.
A growing reason for using equity release is to avoid Inheritance Tax (IHT) - particularly in London and the South East where property values above the £255,000 IHT limit are more common.
Potential
If people take out a mortgage-based equity release product, they can either choose to pay interest throughout the life of the loan or they can opt for interest to be rolled up and repaid at the end of the loan period. With either option, the borrower continues to own their property and to live in it.
Home reversion schemes offer another alternative for older homeowners who want to draw on the wealth in their property. With this option, owners do not take out a loan but agree instead to sell all or part of their home in exchange for a lump sum, a regular income or both. As with a lifetime mortgage, they continue to live in the property. But when they die, the percentage of the property that they agreed to sell belongs to the home reversion company.
The Treasury has announced its intention to regulate home reversion products. However, it is only beginning to consult on the detail and primary legislation that will be needed to bring reversions into the scope of the Financial Services and Markets Act.
This has made it impossible for the Financial Services Authority (FSA) to regulate home reversion plans from October 2004, when it took over the regulation of lifetime and all other mortgages.
Equity release grew strongly during 2003. More than 25,000 lifetime mortgages, worth more than £1bn, were advanced in 2003 according to the Council of Mortgage Lenders (CML). This compares with 16,300 mortgages, worth £655m, in 2002. Growth in the market has been strong during the past two years. New business in the last six months of 2003 was almost triple the value of lending in the first half of 2002. This has shown a slight slow down from the same period last year - perhaps as a result of lenders preparing for regulation.
This takes the overall total of outstanding loans to an estimated 69,000, worth £2.85bn. Although this accounts for 0.2% of the total UK mortgage market, it represents only 0.006% of the estimated unmortgaged equity in the over-65s, and so there is significant potential for strong expansion in the future. It is quite feasible that the equity release market could grow to be worth £50bn in the coming years.
The CML has recently completed research with Hanover Housing Association looking at how the attitudes of people in the age groups 45-54, 55-64 and 65-80 towards their homes and housing wealth might change. More than half of all those who are outright owners want to stay in their current homes, including 72% of those in the 55-64 age group (see chart bottom left).
Attitudes
A total of 50% of people said that they expected their standards of living to decrease 'a little' (39%) or 'significantly' (11%). The chart (bottom left) shows the percentage of outright owners or those with mortgaged properties who anticipated using the equity in their homes to help fund their retirement.
A total of 52% of those with a mortgage and 46% of those who owned outright in the 45-54 age group anticipated using the equity. Although this figure reduces with age there is still a high proportion of people who would consider using the equity in their property.
Awareness of equity release schemes is very high with 80% of those who have a mortgage and 82% of those who own outright having heard of them. Men (78%) were more likely to be aware of such schemes than women (74%). However, as shown in the two charts above, when homeowners are split by social grade and age group, awareness goes up as high as 86% for grade AB and 87% for C1, and peaks at 86% for 55-64 year old outright owners.
There will be additional requirements for lifetime mortgages over and above those for other types of mortgages under the FSA's new regulations. These include specific pre- and post-sale disclosure and additional training requirements for staff involved in the process.
In providing appropriate advice for consumers on equity release, the FSA proposes that there should be three stages. These are whether an equity release product is suitable for the customer, what types of equity release product are suitable, and which providers' lifetime mortgages or home reversion schemes best meet the customer's needs and circumstances?
The combination of an ageing population of homeowners, greater reliance on self-provision, and the decline of the Welfare State, means that equity release is inevitably a serious option for a large and growing number of older people who find themselves asset rich but cash poor. Equity release can make a lot of sense for owners, especially if they do not wish to move or trade down.
The key priority is to make sure that these borrowers, some of whom may be vulnerable, truly understand the nature of an equity release mortgage. There is still enormous capacity within the equity release market which, with the underpinning of a robust regulatory regime, can develop its true potential.
Jackie Bennet is senior policy adviser at the CML and Bob Wright is director of product development at Northern Rock
COVER notes
• Using the equity locked up in a home can be an excellent way of generating cash if other possibilities have been exhausted.
• It is estimated that people aged 65 or over may now hold as much as £460bn worth of unmortgaged equity in their homes.
