Equity release plans provide you with a cash lump sum or regular income. The "catch" is that the money released will need to be repaid when you pass away or move into long term care. With a Lifetime Mortgage, you will owe the capital borrowed and the loan interest accrued. With a Home Reversion Plan, you will no longer be the full owner of the property.
In this guide, you will learn:
With lifetime mortgages where you are not making any interest payments, people will often refer to compound interest as "the catch".
Compound interest refers to the interest accruing on the interest already added to the loan.
Let's look at an example of the balance owed on a lifetime mortgage where you borrow £50,000 @ 5% interest and are not making any payments.
As you can see, despite the interest rate being fixed at 5%, the amount of interest charged each year increases.
But how does compound interest effect the retained equity you hold in your property?
The graph above shows that while the equity release interest is compounding, so is any growth on the property.
Most people have seen steady property growth in the past, and expect to see increases in the future too.
In our example, the retained equity in the property (property value - equity release balance) increases year on year, despite the equity release interest rate being higher than the property growth percentage rate.
But why is this?
While the equity release interest rate is higher than the property growth rate, the lender is only charging interest on the equity release balance. Whereas, any increases on the property are on the total property value.
In our example, the release value is 1/6 of the property value. This means that in year one, the interest of 5% is actually less than 1% of the property value (100% / 6 * / 5% = 0.83%).
Your equity release adviser can provide you with examples of how you could retain equity at your free initial consultation.
One of the most considerable pitfalls with equity release is taking more money than you need.
With a lifetime mortgage, you are charged interest on the money you borrow, even if you are not making monthly repayments. Therefore if you take excess money out of your property, you will be paying more, than you will earn interest on it in a savings account.
What's more, the interest rate charged generally increases as you borrow more money from your home.
For these reasons, I always suggest that you only release enough money to cover your expected outgoings for the next two to three years.
Should you expect to need money after this, you can always look to add a pre-agreed reserve to your lifetime mortgage, which you can access when you need it.
Please see my guide on draw-down equity release plans to learn what they are, and how they can save you money.
Shared Appreciation Mortgages (SAMs) were only available for two years, in 1997 and 1998. Yet, their effect on the reputation of equity release is enormous!
SAMs were loans which allowed borrowers to release a cash sum of up to 25% of their property value.
When the property is sold, the loan would have to be repaid in full, plus a share of any increases in the property value. Here's the "catch", the share would be three times the percentage borrowed. So for borrowers taking the full 25%, they would owe 75% of any property value increases.
Since the late '90s, property values have massively outgrown inflation, leaving the borrowers with much larger debts as a result.
The result is that the banks' profit on these loans can be more than 700%
This is MONEY reported a reader who took a shared appreciation mortgage of £35,000 in 1997 with Bank of Scotland. Her debt had reached £380,000, meaning that the bank had seen a near 1,000% return in their lending. Source: thisismoney.co.uk.
With equity release plans, the older you are, the larger the amount of money that you can borrow.
Although your age doesn't directly affect the interest rate, it does affect the maximum amount you can borrow. In turn, this affects the interest rate, as typically the closer you are borrowing to the maximum amount available, the higher the interest rate.
Let's look at an example:
At age 55, if you wanted to release 25.00% of your property value, the best interest rate would be 4.84% (AER).
At age 75, if you wanted to release 25.00% of your property value, the best interest rate would be 2.70% (AER).
Another, potentially significant, impact of borrowing when you are younger is that the plan will likely last longer than if you borrowed when you are older.
If you are not making interest payments back on a lifetime mortgage, the interest will be added to the total sum owed. We have already seen the effects of compound interest earlier in this article. In this example, the longer the plan runs, the greater the impact of compound interest.
This doesn't automatically mean that younger borrowers should be deterred from equity release. More, it is vital to consider changes to your needs as you move into your later life.
For this reason, I specifically recognise those aged below 60 to be at higher risk of the effects of compound interest.
A potential "catch" of a lifetime mortgage, is that you can be charged a penalty for repaying the loan early.
ERC's can be structured in different ways. Some lenders have fixed penalty charges over a set period. For example, 6% in the first 5 years; 3% in years 6-10; 0% from year 11 onwards.
Other lenders have variable ERC's, which could be 0% but could be up to 25% of the amount that you initially borrowed.
There are various ERC exemptions too. So if you are thinking of repaying early, make sure you discuss this at your advice meetings to ensure any plan you apply for best meets your needs.
Here are a couple of common exemptions:
- Downsizing protection - Allowing you to repay the loan when moving home without incurring an ERC.
- Significant Life Event Exemption - Allowing you to repay the loan within three years of the death of the first borrower, or the first borrower moving into a care home (where a joint application is made).
Remember: a shiny interest rate is fantastic, but not if you are likely to be incurring extra charges if you are planning to repay early.
When taking out a lifetime mortgage, many will consider the transaction as "setup and forget". But this could mean you are overpaying by potentially tens of thousands of pounds over the life of the mortgage.
But how can this be?
We have continued to benefit from house prices outgrowing inflation. We have also seen average lifetime mortgage interest rates continue to fall over time.
So if you took out equity release more than 12 months ago, you might have a higher interest rate than if you were a new client today.
It is essential that you regularly review your finances, and a lifetime mortgage should be no different.
I have written a complete guide on how we have helped existing equity release clients save thousands of pounds.
If you have equity release or are thinking of taking out a plan, do not "setup and forget".
Equity release isn't suitable for everyone, and there may be a better alternative for you.
As part of our financial advice meetings, I explore all other alternatives to equity release. This is an integral part of my financial advice as I will only recommend an equity release plan where it is suitable for your needs.
I have written a complete guide on the alternatives to equity release.
If you have further questions, why not speak with one of our qualified advisors?
Call us on 0207 158 0881 or use our online form to book your FREE consultation.
While a qualified equity release advisor has written this guide, it is not intended to be used as financial nor legal advice and should not be relied upon.
To understand the full features and risks of an Equity Release plan, ask for a personalised illustration.
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