If you need extra cash in retirement you may be tempted to release equity from your home but it can be an expensive and risky choice.
Equity release is becoming a popular way of providing further funding in retirement. If you're asset rich but cash poor, unlocking the value of your home may seem an attractive option, particularly in view of strong house price growth in recent years. Research carried out by The Fool last month revealed that two out of seven people intend to release equity from their homes when they retire. This suggests equity release could become big business, but it can be much more costly than you might think.
Before I look at cost in more depth, I'll briefly explain the two distinct types of equity release: lifetime mortgages and home reversion schemes. Firstly, a lifetime mortgage involves releasing part of the value of your home as a cash lump sum. Interest rolls up on the mortgage loan until the homeowner dies (or moves into a care home). At this point the capital and interest are repaid in full using the proceeds of the property sale.
Alternatively, with the second type - home reversion - the homeowner sells all or a share of their property to a home reversion company in exchange for a cash lump sum. On death the property is sold and the company receives the value of the share they're entitled too.
Although equity release seems a simple enough concept, it's worrying that many people are committing themselves without having any idea how much their loan will actually cost. In fact, it's possible the entire value of your home could be wiped out.
I think equity release should be considered high risk and here's why - if you use a lifetime mortgage to release £50,000 this is how much you would have to repay over various periods based on a fixed interest rate of 6.39% (APR):
Plan Type | Amount Released | Interest Rate (APR) | Amount Owed After Five Years | Amount Owed After Ten Years | Amount Owed After Fifteen Years |
|---|---|---|---|---|---|
Fixed Rate Lifetime Mortgage | £50,000 | 6.39% | £68,151 | £92,892 | £126,614 |
Source: Sample figures from Key Retirement Solutions.
So you can see how easily the amount you owe accumulates. And this is the risky part. Since you don't know how long you're going to live, there's no way of telling how much you'll eventually owe. In this example, if you survive for just five years the total amount you owe would have grown to £68,151. But if you survive for fifteen years it'll cost you £126,614, a staggering £58,463 more.
And what if you survive for twenty years or even longer? The oustanding debt could rocket. There is some protection available in the form of a 'no negative equity guarantee' which is operated by most (but not all) lifetime mortgages. This means you won't owe more than your home is actually worth but I think this is little comfort.
Equity release companies will provide projections of the amount you'll need to repay but this usually assumes you won't live beyond the average life expectancy for your age and as such it can only give you a very rough estimate. Many will live significantly longer than the average which makes projections less meaningful and therefore impossible to evaluate the true cost of a lifetime mortgage.
On the other hand, with home reversion schemes you'll know exactly how much you've borrowed as you'll get the cash lump sum you need up front with no interest payable. But there's a catch. Clearly if you sell a 100% of your home to a reversion company it's realistic to expect a lower cash sum in return. However, it might surprise you to learn you could get back less than half. Take a look at these sample figures:
Plan Type | Client Age | Property Value | % Of Property Sold | Amount Received As % | Cash Lump Sum Received |
|---|---|---|---|---|---|
Home Reversion Scheme | 70 years | £150,000 | 100% | 46% | £69,000 (minus fees) |
Source: Norwich Union.
Does it make sense to hand over your property in return for less than half its current market value? Admittedly, the older you are the more you'll be able to release, but you'll still be sacrificing a significant proportion of the value of your home.
In my opinion, a better solution is to downsize if you can, particularly if you would like to leave a legacy to your family. Encouragingly, our research shows that one in two homeowners plan to move to a smaller home at retirement. The cost of downsizing is far less than you would incur in charges and interest payable on an equity release plan. OK, so you may be perfectly happy in your larger home, but downsizing is much better value for money.
But if you still think equity release is your best option here's five important factors to consider:
- There are over forty different plans on the market so it's a bit of a minefield. Speak to an independent adviser who specialises in this area to help you find the most suitable scheme.
- Borrow only as much as you need. Surplus cash left on deposit will earn far less in interest than you'll have to pay on the amount you borrowed initially.
- If you choose a lifetime mortgage don't be seduced by headline rates. Look at the APR (annual percentage rate) instead to give you a clearer picture of the fees for setting up the plan and the impact of how the interest is calculated.
- Releasing equity from your home can affect your entitlement to certain means-tested state benefits. Consider these carefully before making a decision to avoid jeopardising other important sources of income.
- You'll need a solicitor so make sure you choose one who is familiar in dealing with the legal aspects of equity release. This can help to keep the fees down and speed the process up.