Taxbriefs Commentary Library

Looking under the equity release bonnet

Danby Bloch, 17 Jul 2013


Advisers and their clients who are considering equity release need to understand the principles of what they are getting into and the specific risks that they face. Equity release is often seen as the solution to a wide variety of financial planning problems, ranging from gaps in retirement provision to IHT mitigation and meeting long-term care needs.

Some holistic financial planners are qualified to give specific advice on equity release contracts; most probably are not. But the fact is that all financial planners should understand the key issues.

One key issue to grasp for equity release is the way the accumulated value of rolled up debt increases in relation to property prices (see graph).

It is valuable for advisers and clients because it provides an essential insight into the structure of a lifetime mortgage and the risks involved. Of course, there is one risk that borrowers no longer face: negative equity. Most enders have signed up to the Equity Release Council’s code of conduct, which includes a no-negative equity guarantee.

But with interest rolling up each year, borrowers can run out of equity in their homes, and so find themselves leaving nothing of their homes’ value to their heirs.

The chart shows the rate at which borrowers find themselves with loans equal to the value of their homes, based on different assumptions. One of the main variables is the size of the initial borrowing as a proportion of the home’s value. The chart shows five loan-to-value (LTVs) percentages: 10 per cent, 15 per cent, 20 per cent, 25 per cent and 30 per cent.

This corresponds to the typical range of maximum LTVs, which are linked to age; the older the client is, the higher the proportion of the value of their home they are able borrow. Elderly borrowers can access even more than 30 per cent LTV.

The other key variable is the relationship between the rate of interest on the rolling up lifetime loan and the rate of growth in the value of the property. If the value of the property grows faster than the rate of interest on the lifetime loan, the client will have an increasing amount of equity in the property. This is what most people expect to happen.

But the equity will be eroded if the interest rolls up faster than the rate of growth in the property’s value. The chart shows the different trend lines, assuming that the interest rate is 2.5 per cent and also 5 per cent a year more than the rate of growth in the property’s value.

So, suppose Jess has borrowed 30 per cent of the value of her home and the interest has rolled up at an annual rate of 5 per cent more than the property has increased in value. After 25 years, Jess will have zero equity in the property and her heirs will inherit none of it. But if the property underperforms the interest rate by only 2.5 per cent a year, there should still be equity in the property well after 40 years have passed.

Right now, lifetime mortgage interest rates are around 6 per cent. Mostly, the rates are fixed, with early redemption penalties for those who switch to a cheaper deal. In the past, 7 per cent and more was a very common rate and a lot of people still enjoy it.

So how have house prices moved in comparison? In the last 32 years, prices have risen between roughly five and ten times, depending on the location.

It is only recently – in the last half dozen years – that there has been nationwide stagnation or decline in house prices and the extent very much depends on the location of the property. Looking to the future, house prices might buck the post-war trend and continue to stagnate/decline or they might revert to the previous pattern and grow again.

Borrowers need to understand how an equity release deal works, and the risk that they could possibly use up all their equity and leave their families nothing. Of course, for the lenders, it will continue to look like very attractive business unless there is a long term major catastrophe in the market.

This article first appeared in Money Marketing 11 July 2013.


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Danby Bloch

Editorial Director, Taxbriefs

Danby Bloch is the editorial director of Taxbriefs, chairman of city-based IFAs, Helm Godfrey and director of Nucleus, an independent wrap provider.

Over a period of more than 40 years, Danby has established himself as one of the industry's leading thinkers and  is a respected author, lecturer and trainer on tax and financial planning.




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