Equity release is a means of retaining use of a house or other object which has capital value, while also obtaining a lump sum or a steady stream of income, using the value of the house. The “catch” is that the income-provider must be repaid at a later stage, usually when the homeowner dies. – https://en.wikipedia.org/wiki/Equity_release
So, we have a definition above which I think is pretty easy to understand. In a way this type of transaction has been taking place for years. Shakespeare had the use of someone offering something as collateral for a monetary loan as a plot device in the Merchant of Venice. Pawn broking has existed for centuries and modern banks and financial institutions are carrying on the same, albeit not asking for a pound of flesh, although some borrowers may feel that they may as well be.
Like all financial loans there are numerous options and variables involved with the availability as well as the intricacy relating to the same. There are certain key factors in all equity release schemes and these are:
It is an interest only mortgage
It has to be secured against your main residence
You have to be over 55 years of age to obtain the same
As I have hinted at above there are various ways that the three fundamentals above can change. It is possible to find ERM products that allow capital repayment and some providers are considering allowing borrowers to secure an ERM against a second home. The one true fundamental I suppose is that you have to be over 55 years of age to qualify. The caveat on that for the future in my mind is that as the population gets older then that minimum age may need to be raised as life expectancy increases. I have myself acted for clients who have taken out, repaid and then taken out a further ERM.
So why do people take out an equity release mortgage? This is by no means a comprehensive list but in my experience the following covers why most clients look at ERM schemes:
An easy way to obtain instant funds – provided the property is valued over £70,000.00 at the time of writing and subject to some basic mortgage underwriting criteria it is unlikely that an ERM product cannot be found for someone who wants one.
To take money now to reduce the value of their estate for IHT purposes – personally I think this is perhaps a rare reason to take an ERM but people do.
To help children out now rather than when they pass away – a client said to me once that he wanted his children to remember him for what he was when he was alive rather than what he left him when he had passed away. He (amongst) other clients I have acted for want to gift monies to their children (and others) whilst they are alive to see the benefit/enjoyment that others may have from it.
To fund their lifestyle – living on the south coast as I do, then going on a cruise is expensive. As technology expands and the world gets smaller then those who have retired often want to keep to the lifestyle they had when they were working so ERM options allow them to live the life they want.
Poor pension choices – hardly a day goes by without some scandal or another being revealed about pensions. Taking an ERM can alleviate issues surrounding the same.
They need to repay another mortgage or other debts – it never ceases to amaze me the number of people I have spoken to over the years that assume that debts will just “disappear” when they retire or die. If a loan is still in place against a property or other assets that someone over 55 years of age may have the only option of taking an ERM.
They have no choice – sometimes people have no way to be able to afford the cost of living without borrowing against their own home which is, more than often, the only significant asset they have.
So we have considered various options as to why ERM are an option for people. However, there are alternatives. It is important (we will look at this in more depth in the next chapter) to speak to your clients and make them aware that there are alternatives they may wish to consider. So what alternatives are there to equity release? Again not an exhaustive list but:
They could sell their current home and buy somewhere else
They could raise finance in another way
They could see if their children or another third-party can help them financially
On the face of it I think we can agree that ERMs sound like a straightforward and effective solution to providing funds to the over 55s into their later lives. However, if you speak to many within the legal profession they will recoil in horror at the thought of acting for someone in an ERM matter. Part of the reasoning behind this book is to allay those concerns but where do the “horror stories” originate from? Well I think a lot of the apprehension comes from the Shared Appreciation mortgage “scandal” of the 1990s.
Tens of thousands of borrowers were sold shared appreciation mortgages (SAM) in the late 1990s by both Bank of Scotland and Barclays to help them fund retirement, but many are now trapped in unsuitable homes by debts that rapidly increased to many times more than they borrowed.
How it worked:
The owner of a £200,000 house in 1998 would sign up to a SAM and be given £50,000 cash.
If that house were sold in 2014 for £600,000, the owner would be required to hand over £350,000 to redeem the mortgage.
Sale price: £600,000
House value when SAM taken out: £200,000
Increase in value: £400,000
75% of increase in value: £300,000
Original loan: £50,000
Total repayable: £350,000 (a return for the bank of 600%)
Borrowers thought this was a marvellous innovation as it was marketed as a way of getting instant funds without having to involve solicitors as the banks handled everything themselves “in house”.
While for normal mortgages Bank of Scotland had a 60 per cent conversion rate from mortgage offer to the funds being drawn, for SAMs they had a 95 per cent conversion rate.
There were only two interest rates which they considered were sufficient for the launch as they were trying to keep things as simple as possible given “some of the product features were complicated enough to communicate as it was.”
In fairness to Bank of Scotland, the lender did initially ask that applicants seek advice from a financial adviser or a solicitor to ensure they really understood what they were signing. Applications that came without the input of a financial adviser were sent back. However, solicitors did not have to be involved. Eventually they abandoned allowing financial advisors to be involved as they were suggesting to clients not to take out the products. If you were working in one of those banks and your livelihood depended on these products being successful then I can understand why they would be reluctant to allow anyone to place resistance in their path. Please keep in mind that these products were available in a different time when the amount of regulation in place for financial products being sold to the public was less stringent than those in place now.
Targeting older, cash-poor customers wasn’t the only tactic that questions would be raised about today. Bank of Scotland also forced those taking a SAM to sign contracts in just two weeks rather than the three months borrowers were normally given to decide whether to take a mortgage.
In the in the late 1990s, no one expected house prices to rise by as much as they did. The Nationwide house price index shows prices rose by 270 per cent between 1997 and today. A house could double in value in less than two years.
When the loans became available, applicants tended to be in their 50s and 60s. Two decades later, some of these borrowers – now in their 70s and 80s – owe Bank of Scotland hundreds of thousands of pounds for loans worth just tens of thousands when they were taken out in the late 1990s.
There is a group of pensioners who have formed an action group to take proceedings but no proceedings have been issued as yet at the time of writing. Do you think they would have done so if they had solicitors to pursue with healthy professional indemnity insurance policies to claim on? Based on this, that is why the legal profession, financial advisors and financial institutions are wary of ERM matters.
So, if the clients decide that they wish to proceed with an ERM application there are two distinct types of ERM that they can consider.
A Lifetime Mortgage involves taking a type of mortgage which does not require monthly repayments, although with some plans rather than roll up the interest the borrower can opt to make monthly repayments if they wish.
The borrower retains ownership of their home and interest on the loan is rolled up (compounded). The loan and the rolled up interest is repaid by their estate when they either die or move into long term care. If the borrower is part of a couple, the repayment is not made until the last remaining person living in the home either dies or moves into care, meaning that both of them are free to live in their home for the rest of their lives.
If they take they take out a Lifetime Mortgage, they can choose to receive their funds in a lump sum or in smaller, regular amounts. There is also an option available to increase the amount they have borrowed as and when they want to, up to the maximum limit agreed with the plan provider. They can also elect to protect some of the value of their property as an inheritance for their family, meaning that they can benefit from releasing equity while still retaining something to pass on to their children. Some people may be able to release larger lump sums due to impaired health or may prefer to make monthly repayment in part, or in full, with an option to roll up at a later date if the monthly repayments became unaffordable.
Home reversion plan
A Home Reversion Plan also allows a borrower to access all or part of the value of their property while retaining the right to remain in their property, rent free, for the rest of their life. With a Home Reversion product the provider will purchase all or part of the house taking into account the age and health of the owners and will provide them with a tax free cash lump sum (or regular payments) and a lifetime lease, guaranteeing them the right to stay in their property rent-free for the rest of their life. There is no day-to-day interference and no restrictions on treating the house exactly as before; as a private home to live in freely.
The percentage they retain in their property will always remain the same regardless of the change in property values, unless they decide to take further cash releases. At the end of the plan their property is sold and the sale proceeds are shared according to the remaining proportions of ownership. In a way this is very similar in style to shared ownership without the need for ongoing payments.
With both a Lifetime Mortgage and a Home Reversion Plan it is possible to give a homeowner some certainty in their future finances. With a Home Reversion Plan the client knows precisely what he/she has parted with and, equally, what has been ring-fenced for later use, possibly to leave in a Will. With some Lifetime Mortgages it may be possible to also ring-fence an element of equity.
However, you need to be aware that Home Reversion Plan schemes are a big risk for your clients and you will not find them being offered by the main ERM financial providers. If you check with your Professional Indemnity insurance providers then don’t be surprised to find that they will be wary to offer cover if you undertake that type of ERM matter.
To protect your professional indemnity insurance, your reputation and that of your firm then you must take an advice you give on an ERM matter seriously. In the next chapter we will look at the process that I would suggest you follow when advising clients. So without further ado, let’s take a look.