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Table of Contents
This paper will look at Equity Release Mortgages and it’s increasing popularity. We will investigate its increase and its reasons for the increase due to longer life expectancies and pensioners not saving enough for retirement. We will also investigate the reasons that people may find that though the equity release mortgage may seem too good to be true at first, it does come with some limitations due to the valuation methods and what the safeguards and other options these people have are. We will look at how companies value their equity release mortgages and the assumptions that they make and why they could be wrong. We will then value the Equity Release Mortgage and see how the value differs and we will be particularly interested in the No Negative Equity Guarantee Valuation as this has caused a lot of problems We will find that many people are drawn into the idea of a quick lump sum that’s tax free which is great in the short-term but can have major impacts in the long-term. We will conclude this paper on improvements that can be made in this market and the type of people who should be looking into this product and the possible alternatives to people looking to boost their finances in retirement.
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1.1 What are they
Many retirees need to think carefully about how to use their finances if they have not saved enough through pensions. People may not look at their home as part of their financial planning, but if its value has increased, they may have saved without realizing it for their future. The equity release mortgage is a way for those who retire to boost their finances. Equity release collects tax – free cash from your property by effectively receiving a loan secured in your home. You must comply with certain criteria before you take out this loan. First, it is only available to people over 55 years of age and you need a good credit score to get this loan. You also must have a home worth at least £70,000 and the home must be your main residence and not subleased. The value of the home may differ between different companies. For example, for Aviva you must have a home worth at least £75,000. You must also have financial assistance before taking these products out as they are not suitable for everyone. According to Brean Horne (2018), on average equity release will give home owners £77,934.
You are still allowed to stay in your home even after equity release. There are two main types of equity release. They are a home reversion scheme and a lifetime mortgage. For the home reversion scheme an equity release company will buy a fixed share of your property from you and then wait for the value of that share to increase. It will take a lot of time before the value of that share increase and the equity release company won’t get any money until the property is sold. For this reason, the amount the equity release company offers to you will be well below the shares actual value These are becoming much less common and account for less than 1% of the market. The far more common alternative is the lifetime mortgage. With these, the loan comes with a fixed interest rate and unlike a conventional loan, you don’t pay this loan off with regular instalments. The debt is rolled up, so the interest is calculated on an ever increasing total and is only repaid when the property is sold. The property is usually only sold when the homeowner dies or moves into long term healthcare and the value of the loan accumulates over time. In some cases, the loan can also end by early repayment. At the time of exit, the lender takes possession of the property and sells it to repay the accumulated value of the loan.
There are many different types of lifetime mortgages for equity release and the one which we just talked about was a standard lifetime mortgage. The Telegraph Retirement Solutions (2017) talks about the different types of lifetime mortgages that are on offer for those considering equity release. The mortgages for Drawdown lifetime work in the same way standard lifetime mortgages but with an additional degree of flexibility. Drawdown offers both unexpected and planned future expenditure opportunities. Drawdown allows you to draw money down in stages as and when you need it rather than taking out a larger sum. The advantage of this option is that interest is only applied to the money you have taken so if you take out smaller amounts of money the interest you pay at the end won’t be as large as if you were to take out the full lump sum like in a standard lifetime mortgage. This would appear to be a much better option than the standard lifetime mortgage. The Enhanced Lifetime Mortgage plans are special types of plans for those with medical conditions. They enable you to release more money from your home than a Lifetime Mortgage and you may end up receiving beneficial rates. If you have health conditions, equity release can work to your advantage as you may qualify for an enhanced plan. For the Protected Lifetime Mortgages if you want to guarantee an inheritance for your family, due to the property being sold, this type of mortgage is available. With this type of mortgage, you can guarantee an inheritance to the people you choose by choosing to protect a percentage of the value of the property to ensure that those you want to get the inheritance. The Interest Payment Lifetime Mortgages has come around recently and meets the growing need of people wanting to take equity out of their homes. They work in the same way as a Lifetime Mortgage, however with these you are able to make regular payments on the interest that accrues over the lifetime of the loan. Each pound you pay off reduces the amount that your equity release provider takes out of the value of your home when the plan comes to an end. Finally, the Interest Payment Flexible Lifetime Mortgages come with some flexibility in how you make the payments. If you want to make regular payments each month, you can make full or part payment towards the interest. However, if for any reason, you decided that you no longer want to make payments, you can stop and the product can be switched to a regular Lifetime Mortgage where the interest rolls up instead. This product offers the greatest degree of flexibility
As we can see from the graph, published by the Equity release council (who are responsible for the provision of advice on equity release), there has been a huge increase from the first quarter of 2016 to the first quarter of 2018 of the total value of lending and the total number of new customers. In just two years it has increased by over two times. We can clearly see that this product is becoming a lot more popular and demand for it has increased. The most popular were the Drawdown Lifetime mortgages, where 68% of buyers of the equity release product opted for the arrangement.
2016 saw £2.15 billion of housing wealth unlocked by over 55’s. Seeing as the first quarter of 2018 has more than doubled the first quarter of 2016, It’s possible that over £4 billion pounds of housing wealth could be unlocked by over 55’s.
This increase in popularity could be due to a greater awareness of this product and the no negative equity guarantee which we will talk about more later. The Chairman of the Equity Release Council (David Burrowes, 2018) commented that, “nearly 70% of all homeowner equity belongs to households aged 55 and over” and so he argued that equity release provides a way for the next generation to get onto the property ladder. Carrie Ann (2018) argued that there are a variety of reasons for this increase. These include the support of their retirement income, payment of existing mortgages and debt or assistance to their children on the property ladder. In some circumstances, people are also using equity release to reduce their Inheritance Tax due to the fact that releasing equity from the home reduces the value of the home and so there is less tax to pay. However, it should be noted that paying less tax is not the main reason as there is still a large loan to pay off from the home.
Though equity release sounds like a great thing there are downsides associated to it. The main problem with it is that not everyone can do it and it seems that only wealthier large homeowners will be able to get a good cash sum. Brean Horne (2018) gives quite a few alternatives to equity release mortgages. There is an unsecured personal loan which could be a cheaper option if the amount you want to borrow is small and you can keep up with repayments. But advises you shouldn’t use an unsecured personal loan to pay off your mortgage, as the interest you’ll face is likely to be much higher than your mortgage interest rate. There is a mortgage extension, meaning that if you haven’t paid off your mortgage by the time you retire, it might be possible for your lender to extend the term of your mortgage for another 5 or 10 years. However, some lenders may have an upper age restriction of 65 years. There is Remortgaging meaning that If you speak to your lender, or a mortgage broker, you may be able to secure a new mortgage deal over your property, which can bring down your monthly payments. As an example, you may be able to move to a deal with a lower loan-to-value ratio, or one where interest-rates are lower. This may not be possible in all cases; however, lenders may be reluctant to offer a new mortgage deal to applicants who are older or retired. Downsizing. If you need to release a significant amount of cash, selling your home and moving somewhere smaller could put more money in your pocket. It’s important to consider the cost of selling a house, though, as you will need to factor in things like agent fees, removal costs and stamp duty costs. Speaking to a mortgage broker can help you figure out the best mortgage product if you’re looking to remortgage or move to a new house. People may not like this though as there is a big hassle in moving but with the Equity Release Mortgage, you are still allowed to live in your home.
The No Negative Equity Guarantee makes sure that the amount of loan plus interest you need to pay off the plan can never be higher than the value of your home. It means that the borrower is protected if there is a downturn in the housing market, the house goes down in value, and the amount of debt you have is higher than the amount it would sell for. All plans approved by the equity release council must offer this promise of the No Negative Equity Guarantee. This in theory sounds great. However, Kevin Dowd (2018) has described this No Negative Equity Guarantee as a “ticking time bomb”. He argued that the valuation of these No Negative Equity Guarantees were done differently by different firms and some firms were not even incorporating standard market practices into their valuations. Most firms agreed there was a relevance of property growth and volatility assumptions. This is a big concern, due to the fact that these things don’t appear in the option pricing equations and firms used a variant of the Black Scholes model using a key assumption of property growth.
The Prudential Regulation Authority (PRA), are responsible for the regulation of these equity release mortgages and the guidelines for selling them. Peter Walker (2016) discusses about the rules that the PRA sets about for valuing the equity release mortgage and what constitutes as a fair price. or insurers, the PRA’s rules on valuation are set out in Valuation 2.1 of the PRA Rulebook, and the requirement is to value “assets at the amount for which they could be exchanged between knowledgeable willing parties in an arm’s length transaction”.
Equity Release mortgages have uncertain cashflows and complex features to value such as the No Equity Guarantee and are not actively traded. The lack of active trading means fair valuation is usually on a ‘mark-to-model’ basis, with a requirement to maximise the use of observable market inputs, and, depending on the purpose of the valuation, with adjustments applied. Mark-to-model is a pricing method for a specific investment position or portfolio based on internal assumptions or financial models. Due to these assumptions this can have some negative consequences to the valuation of the Equity Release Mortgages. Mark-to-model assets essentially leave themselves open to interpretation, and this can create risk for investors. The PRA is very open to discussion on improving the valuation techniques and how they can be resolved as there is a quite a lot of uncertainty between companies as how to value the no negative equity guarantee.
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