Introduction

Many of the products sold by the personal finance industry are unnecessarily complicated, probably because the industry can charge higher prices and make bigger profits by selling complicated, differentiated products rather than simple ones. Examples of this are: endowment assurance instead of tracker funds with separate life insurance; split capital investment trusts instead of ordinary ones and endowment mortgages instead of repayment mortgages.

Now that final salary pensions are less common and money purchase pension schemes have lost much of their value because of the stock market crash, additional sources of income for retired people are very desirable. One such source, for those who own houses, is called ‘equity release’ because they ‘release’ a house’s net equity, the difference between its market value and any mortgage, to provide income.

In this paper a model equity release scheme is described and its benefits and limitations are analysed. Then this simple model is compared with commercially available schemes.

Model equity release scheme

In this model equity release scheme a lender provides a householder with a particular monthly income. As the months pass the debt to the lender builds up. After a defined number of years, the monthly income terminates, the house is sold, some of its value goes to pay off the debt and the rest goes to the householder or his or her heirs.

Table 1 shows how the debt builds up in an example where the income provided by the lender is £1000 per month at an interest rate of 0.5% per month. The debt arises from the income received and the interest charged. At the end of the first month the debt is £1000 plus £5 interest, i.e. £1005; at the end of the second month the debt is the £1005 plus another £1000, plus the interest of 0.5% of £2005 i.e. £10.025, giving a total debt of £2015.025. Continuing this calculation the table shows how the debt builds up month-by-month and year-by-year.

Table 1

Build up of debt for monthly income of £1,000 and interest rate of 0.5% per month.

Table 1 shows that equity release is very time dependent. Initially the debt owed is mainly the sum, which is small, of the monthly income provided plus the interest paid on this, which is even smaller. For example, after one year the sum of the monthly income is £12,000 and the interest paid is only £397.24. However, after a time the sum of the income benefits becomes large and as does the interest charged. After ten years the sum of the income received by the householder is £120,000 and the interest incurred is £44,698, so that the householder owes a total of £164,698. After twenty years the debt is £464,351 and the householder has received £240,000 and £224,351 of interest has been incurred. After 30 years the difference is dramatic: a debt of £1,009,537 of which the householder has received £360,000 and the interest is £649,537. Such is the inevitable consequence of compound interest.

A 75 year-old householder who owns a house worth £500,000 could agree with a lender a contract for £1000 per month with a ten-year duration. Such a householder might have already spent his liquid assets and the equity release would replace them for ten more years. On sale of the house the householder would still receive £335,302, and if he were still alive at age 85 this would pay for residential care, or the rent on a flat. Also, at age 85 he could buy an annuity at a good rate. Even if he had no financial resources other than state pensions there would be little chance that he would suffer hardship.

On the other hand a 65 year-old householder also with a house worth £500,000 who made a contract for twenty years would be left with only £35,649 at age 85. In practice, he would need to own a house worth £800,000 to afford such a 20-year contract. With this at age 85 he would have a financial status similar to that of the first householder. Obviously, one method of avoiding this problem is to accept a lower monthly income, e.g. a monthly income of £500 per month for ten years could be supported by a house valued at only £250,000. However, a monthly income of much less than this would be unlikely to make much difference to the total income of most householders.

In this example an interest rate of 0.5% per month was assumed, about 6% per year. How should such an interest rate be determined? The answer is by comparison with ordinary mortgages. At the present time the Financial Times (31 st January 2009) best buy mortgages are in the range 3.5% to 5.0% with deposits of 10% or 25%. In principle the equity release scheme discussed above should have a lower interest rate because from the lender’s viewpoint the equity release scheme has a lower risk, virtually zero. There are two provisos for this: that the householder properly insures his house, but virtually all householders do this anyway; and that the duration of the contract ends when the householder still has substantial equity in the house. None of the risks of younger mortgages apply to retired householders. The latter cannot become unemployed, and if they become ill it has no effect on their equity release contracts. Their equivalent of a mortgages’ deposit starts off at 100% and declines slowly, in the example discussed above, to 67%, in comparison with the 10% or 25% deposit required for an ordinary mortgage.

The above discussion ignores the effect of inflation. In practice the householder, just as with a pension, would like the income to rise in line with inflation following the consumer price inflation index. For example, if this index were 3% in the first year, he would like to get £1030 per month in the second year. This would produce a corresponding increase in the accumulated debt. However, this would not give a problem if the house-value inflation were at least as much. Even if the opposite were the case it would initially just reduce the excess value that would finally go to the householder or his estate. There would be no need to guess what the inflation rate would be years into the future because the house could be revalued from time to time to check whether or not the lender continued to have no risk. (In the unlikely event that this was not so, the lender could still be protected if the lender, in this event, could terminate the contract earlier than planned).

The above discussion shows that in its essence equity release is simple and relatively inexpensive for a contract of limited duration, e.g. ten years. It also shows that it is virtually risk free for lenders so householders should pay interest rates as low or even lower than that applicable to ordinary mortgages.

Commercially available equity release schemes

This section gives only a brief summary of commercially available equity release schemes based on an Internet search and a booklet ‘sponsored by Key Retirement Solutions, the UK’s leading Independent Financial Advisor specialising in equity release.’ It deals only with ‘lifetime mortgages,’ which are the most common form of equity release.

Lifetime mortgages are similar to the simple models discussed above but with important differences. The simple models have a fixed term, e.g. ten years, whereas a lifetime mortgage, as its name implies, continues until the householder dies or goes into residential care. The analysis of the model shows that a relatively short period, e.g. ten years, is best and that this is suitable for an older householder of age 75 or more. On the other hand commercial lifetime mortgages are sold to householders as young as 55 and can continue for the lifetime of the householder. This will often be twenty years or more and then most of the equity in the house will go to repayment of the loan and most of this will be for interest as shown in Table 1. Documents on commercial lifetime mortgages also give an impression that there may be an upper age limit for them, e.g. 80 years. If this were so it would be a pity because lifetime mortgages are particularly suitable for householders in their eighties.

It is apparent that commercial lifetime mortgages are more complicated than the model. With the latter the progress of the loan is predictable with certainty. With the former this is not so because the age of the householder at death is not certain but is a matter of statistical probability. Also some lifetime mortgages guarantee that there will be nothing extra to pay if the final amount owed is more than the equity of the house. This is also a matter of probability. The lender covers the cost of both of these in the interest rate charged, giving scope for overcharging. Also lifetime mortgages do not usually pay a fixed amount monthly, (though ‘drawdown mortgages’ allow money, say £2,000 to £5,000, to be withdrawn at will up to the maximum agreed, and interest is paid only on the money withdrawn).

The interest rate charged is obviously the main factor in determining the value of a scheme. In the analysis of the simple model it was argued that the interest rate charged should, if anything, be less that the interest charged on a normal mortgage. However, according to one quotation ‘commercial lifetime mortgages usually have higher interest rates applied to them than standard mortgages because of their long duration’. Another states, ‘lifetime mortgages usually have higher interest rates applied to them than standard mortgages, as the provider doesn’t receive any payment during the lifetime of the mortgage’. Such reasons do not seem plausible. In practice, the interest rates will be constrained by the level of competition in the equity release market (which does not seem to be high), and what would put off prospective customers. In commercial schemes there are additional charges including application fees and those for the valuation of the house and for payment of the householder’s solicitor. (Caveat emptor is applicable to financial services contracts).

Conclusion

Equity release schemes could be a useful additional method of providing cash or income to elderly householders. The paper shows that from the viewpoint of the householder such schemes are best if their duration is limited say to about ten years. With such a duration, when the house is sold and the mortgage is paid off most of the money goes to repay the borrowings and less goes for interest. Also the householder retains much of the equity released. Commercial lifetime mortgages, which are more complicated than the simple models, can be sold to much younger householders and continue for their lifetime. There is then a high possibility that most of the equity released will go for interest and the householder will retain little of the equity.

There are, of course, other methods of releasing money from a house’s value, for example by ‘downsizing’. A householder owning a house valued at £500,000 could rent it out for say £3,000 per month, and reside in a flat at a rent of say £1000 per month, giving a net income of £2,000 per month, twice as much as the simple model discussed above. However, this involves the bother and cost of moving house and a large reduction in the quality of the accommodation.

Acknowledgement

Table 1 was taken from computer calculations performed by B.D Mills. These calculations gave monthly values up to 360 months and for interest rates of 2, 3, 4, 5, 6 and 7%. With these, tables similar to Table 1 can be prepared for other interest rates.