Cashing in on your home
Amid a credit crunch, a stagnant property market and tightening lending criteria, one area of financial services continues to thrive - equity release. In fact, as nerves fray over the housing market, equity release is bigger than ever, especially among those planning how to fund their retirements.
According to the voluntary regulator of the industry, Safe Home Income Plans (SHIP), by 2006 the equity released from UK homes had reached £1.2 billion - more than double the amount in 2000 and up from £32.5 million in 1995.
With this growth has come controversy, however. The popular image of the equity release adviser in a pin-stripe suit with a wide smile and pound signs in his eyes has not been entirely extinguished, despite the fact that both lifetime mortgages and home reversion plans are now fully regulated by the Financial Services Authority (FSA).
But times are changing and, while consumers must still tread very carefully on what can be treacherous ground, sometimes equity release can make practical and even financial sense.
So how do equity release plans work? Some 95% of plans taken out are lifetime mortgages, according to SHIP. Under the terms of a lifetime mortgage you take out a loan against a portion of your property. The loan does not need to be repaid until you die, sell your house or go into a care home.
The older you are, the more you can borrow, but you can only borrow up to a limit of 50% of the value of your property. Interest on the loan, which is typically set at a fixed rate, builds up over your remaining lifespan, but most providers - and all SHIP members - limit the final debt to the value of the home at the point of sale. As a result, you will never owe more than the value of your home.
This is an important safeguard as, even with the cheapest lifetime mortgages, the final debt can be huge.
The other type of equity release plan, the home reversion plan, works slightly differently. Instead of borrowing against your house, you actually sell a portion of your property. More money can be released through this type of scheme, as it’s possible to sell the whole of your property.
You continue to live there until you die or move into a care home. But, what you get in return for a chunk of your home will be significantly less than its market value – typically between 30% and 60%. So you could end up selling 50% of your £200,000 home for just £30,000.
This is why, despite the growing number of plans being sold, there remains great caution among homeowners about equity release schemes, according to Louise Cuming, head of mortgages at Moneysupermarket.com. “UK borrowers have an overriding urge to become mortgage free,” she says. “And once they have reached this goal, statistics show that the vast majority do not want to re-enter the borrowing arena in retirement by taking out an expensive lifetime mortgage product.”
Under FSA rules, providers and advisers offering the schemes must also exercise caution, which means exhausting all alternative ways of raising money first. “This could mean a homeowner using their savings, downsizing to release equity, raising cash by other means – through a mainstream mortgage or loan, for example – or asking their family for help,” says Dean Mirfin, director at equity release independent financial adviser Key Retirement Solutions. “If none of these options are feasible, we would then look at equity release.”
The proceeds from equity release plans are not always used to buy fitted kitchens or Nile cruises – in the right circumstances, releasing equity from your home can play an important role in your retirement plans.
And there is a use for released equity that has not yet caught on, says Mirfin, which hinges on recent changes to annual pension contribution limits. For most of the term of your pension, an annual limit related to your salary is imposed on your contributions. However, in the year leading up to drawing your pension, unlimited contributions can be made – providing your separate ‘lifetime’ limit is not exceeded. This is when it can be tax-efficient to use funds from your home to boost your pension income, says Mirfin.
“Any lump sum you release from the property you live in is tax free, while what you pay into your pension is not taxed either. So if a higher-rate taxpayer releases £60,000 and uses it to top up their pension pot, they effectively get a £40,000 windfall. They could then release 25% of this pension pot tax free.”
A drawdown facility, which is now offered by more than half of lifetime mortgage providers, takes this opportunity a step further. Drawdown allows borrowers to keep back some funds in a separate account and only pay interest on them when they are accessed.
“This means you can leave funds in a drawdown facility at no cost and use them to top up your pension pot each year,” says Dean Mirfin. “Basically none of these transactions are being taxed, so they make for financially sound retirement planning.”
According to financial data provider Moneyfacts, it is becoming increasingly easy for homeowners to release equity from their homes. In mid-November 2007, two lifetime mortgage providers – New Life Mortgages and Prudential – reduced the minimum qualifying age for their plans from 60 to 55, even though average life expectancy is rising.
“The average age to take out a lifetime mortgage is currently around 70,” says David Knight, a financial analyst at Moneyfacts, “but with many pension pots currently proving to be inadequate, many people will need to supplement their pensions at an earlier age, by releasing equity in their homes, for example.”
But the longer a lifetime mortgage runs for, the higher the price you will pay, warns Knight. “Releasing £50,000, at 6.49%, from the value of your home at the age of 55 will see your debt grow to a staggering £240,818.96 by the age of 80 – which is almost five times the amount originally borrowed.”
Releasing equity, even to supplement your pension pot, may not be a shrewd decision if you do it too early in your retirement.
Ray Boulger, senior technical manager at broker John Charcol, agrees that borrowers should be aware that they may live longer than they expect. “These plans should really only be entered into when you are well into retirement. If you take a plan at 60 and then live to 100, you may find yourself in trouble if you have used all your assets.”
However, equity release can be useful in arranging your finances to keep your inheritance tax (IHT) liability to a minimum, says Boulger. But before you start, bear in mind that IHT thresholds change all the time. For example, it was only in October 2007 that chancellor Alistair Darling announced that the minimum IHT threshold of £300,000 would be doubled for married couples and those in civil partnerships who have not used their allowance.
“And if the Conservatives get in at the next election, they are talking about raising the threshold to £1 million,” adds Boulger. “Borrowers of lifetime mortgages who then want to back out of their plans will have to pay hefty penalties in the first five years – the typical length of tie-ins across the market.”
But extracting money from your property and giving it away to your children can reduce the value of your estate to bring it under the IHT threshold, while the interest building up on the loan will reduce it further still.
“Such an arrangement helps avoid tax at both ends,” says Boulger.
“The lump sum will be tax free and so will the money you give away – providing you live another seven years. This is why the sum of money is called a potentially exempt transfer.”
An increasing number of retired homeowners are going down this avenue to help their children or grandchildren buy their first property. According to figures from the Council of Mortgage Lenders, only 10% of first-time buyers received family help when buying a first property in the mid-1990s, compared with 45% today.
Divorce is another circumstance where equity release can be a useful tool, both financially and emotionally. “The divorce rate among the over 50s has soared in recent years, and rebuilding separate finances can be very difficult,” says Mirfin. “This is because you have reached a time in life when you earn less or possibly nothing at all and are unable to get on an even keel again. We have dealt with cases where equity in the home is released to allow one partner to set up on their own while the other stays in the property.”
In such cases, looking at equity release schemes exclusively in financial terms, both parties lose out. But they can provide what the industry calls ‘embedded value’, says Mirfin. “Embedded value is the key to whether it makes sense to take out an equity release plan – is there some value in doing so?”
Definitions of value will, of course, vary from person to person. “Whereas some people want to spend the last years of their life travelling the world together, it’s just as important for others to split up and enjoy their twilight years alone.”
An equity release scheme, where the money borrowed against equity in the property (up to a maximum of 50%) is subject to interest charges and although the borrower makes no payments during their lifetime, the monthly interest repayments will roll up and be added to the original debt, which will be settled on the borrower’s death. A lifetime mortgage is distinct from a home reversion scheme in that the lender never owns part of the property. But most lifetime mortgages are sold with a no negative equity guarantee. This means that if the loan is greater than the property’s value it’s a problem for the original lender and not the homeowner.
An unexpected one-off financial gain in cash or shares, generally when mutual building societies convert to stock market-quoted banks. Also windfall tax, a one-off tax imposed by government. The UK government applied such a measure in the Budget of July 1997 on the profits of privatised utilities companies.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
The Financial Services Authority is an independent non-governmental body, given a wide range of rule-making, investigatory and enforcement powers in order to meet its four statutory objectives: market confidence (maintaining confidence in the UK financial system), financial stability, consumer protection and the reduction of financial crime. The FSA receives no government funding and is funded entirely by the firms it regulates, but is accountable to the Treasury and, ultimately, parliament.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
A term to describe financial products or ‘plans’ that help older homeowners turn some of the value (equity) of their homes into cash – a lump sum, regular extra income, or sometimes both – and still live in the home. There are two main types of equity release: lifetime mortgages and home reversion plans (see separate entries for both). Whichever type you choose, you borrow money against the value of your property, on which interest is charged, and the loan is repaid when the house is sold after your death.
Home reversion plan
An equity release scheme whereby you sell part or all of your property to a home reversion provider, in exchange for a cash sum or income and you are guaranteed occupancy for life. On your death, the agreed proportion of the proceeds from the house sale reverts back to the provider and the rest is distributed to family. Although you don’t repay the loan until you die and have lifetime occupancy, the cash raised will not reflect the true value of the part of the property sold and you lose the right to any future growth in the part of the property you sold.