Why equity release should only be a last resort

Equity release schemes allow pensioners to unlock cash from their homes. Despite an improving reputation, these deals can backfire badly.

Pensioners are increasingly looking at ways to improve their income. And for many, one obvious route is to look at how to cash in on their biggest asset: their home.

One way to do this is to downsize. This involves selling your existing home and buying a smaller or cheaper replacement, perhaps in a different part of the country or even overseas. However, thanks to estate agent's fees and Stamp Duty, the costs of downsizing can amount to tens of thousands of pounds.

The equity release alternative

In the Eighties, an alternative to downsizing started to take off: equity release. It allowed pensioners to unlock some of the value tied up in their home, without having to move or sell. In effect, these plans involve 'selling' some of your home to an insurance company in return for a lump sum, a 'drawdown' amount to dip into as and when you need it, or a monthly income paid until you die.

In return for this one-off payment or income, an insurance company either secures a 'lifetime mortgage' against your home (the most common option) or takes ownership of part of it. When you die, this loan will be repaid, either from your estate or by the sale of your house.

Lifetime mortgages account for about 98% of the equity release market, with the other 2% being 'shared ownership' schemes known as home-reversion plans.

Both lifetime mortgages and home-reversion plans are regulated by City watchdog the Financial Services Authority. Also, the Financial Ombudsman Service can award compensation to victims of mis-sold equity-release plans.

The pros and cons

The relative attractiveness and risks of equity release depend on a number of factors, including:

1. Your age: although equity release is open to anyone aged 55 and over, most applicants are in their late sixties and beyond. For joint applications, payouts will be based on the younger applicant's age.
2. How much you can borrow: this varies according to your age, state of health and the value of your property (less any loans already secured against it). The older you are, the more you can release. Also, the larger your equity, the more you can pull out to live on.
3. Interest rate: obviously, the higher the interest rate charged, the faster your debt will rise.
4. Provider and adviser fees: Providers charge arrangement fees that can be as high as £2,000. Also, your financial adviser will bill you a further fee for their advice.
5. Large exit penalties: if you change your mind and decide to quit an equity release plan, then the early-exit fee could be as much as a quarter (25%) of your original loan.

Of course, if you dig deep into your equity, then this could mean that your entire property will be taken by an equity release provider when you die. In some cases, this could leave your family and other beneficiaries with little or nothing to inherit from your Will. Then again, all equity-release providers provide a 'no negative equity' guarantee that means your estate will not owe more than the value of your home.

In addition, some plans allow you to guarantee an inheritance to your family by 'protecting' a proportion of the value of your home. Lastly, if you have a joint plan and your spouse or partner dies, you can continue to live in your home until you die.

The danger of compounding

The big problem with a lifetime mortgage is that you make no monthly repayments during the life of this loan. Instead, interest rolls up until you die, steadily increasing your debt. What's more, the interest rates charged by these plans are much higher than those charged by mainstream mortgages.

As a result of compound interest, your debt can grow exponentially, as this worked example shows:

Here's how this loan will grow over time, thanks to the relentless rolling up of compound interest:

As you can see, the original £80,000 grows to over £107,000 after five years, more than £143,000 after 10 years and nearly £460,000 after three decades.

Of course, over long periods, house prices may well increase, thus lessening the relative impact of this snowballing loan. Then again, with UK house prices outside London back to where they were in 2006, there is no absolute guarantee of rising house prices, even over a 10-year period.

Because of this 'remorseless rolling up of interest', I regard equity release as a last resort for pensioners desperate to sustain reasonable standards of living.

Are these plans safe?

During the Eighties and early Nineties, a huge mis-selling scandal grew to encompass almost the entire market for equity release. Commission-hungry advisers had pushed elderly homeowners into releasing equity and using this money to buy investment bonds that later crashed in value. This caused financial problems for countless pensioners, with thousands losing their homes.

As a result, SHIP (Safe Home Income Plans) was launched in 1991. This trade body was dedicated to cleaning up the market for equity release by setting minimum standards for its members to meet.

After 21 years of campaigning for safer equity release, SHIP relaunched itself on 28 May as the Equity Release Council (ERC). At the same time, it threw open its membership to include financial advisers, lawyers and surveyors, as well as equity release providers.

ERC claims that, for the first time, "all aspects of equity release advice and product provision will be covered by one body committed to the highest standards of consumer protection and education."

In addition, the ERC is working with its new members "to develop a broader code of conduct that will complement the consumer guarantees that existing members offer customers."

While the relaunch of SHIP as the ERC will bring new members under its wing, it will be some time before a tighter code of conduct is agreed.

More on retirement:

How much you need to save for retirement

Pensions vs ISAs: how to save for retirement