Equity release is becoming a popular way of funding a cash shortfall in retirement. But is downsizing your home a better option?
I'm not a big fan of equity release. This time last year I criticised these schemes in my article Why You Should Avoid Equity Release. My biggest objection then was that equity release -- a way of unlocking capital from your home -- can be an extremely expensive way to fund your retirement. So, twelve months later, has my opinion changed?
Equity release is certainly gaining popularity. David Blunkett, the former Work and Pensions Secretary, recently told the silver generation to think about using equity release to finance retirement. He felt that was more important than preserving an inheritance for their families.
And Fellow Fool writer, Harvey Jones, has explained why equity release is thriving despite the credit crunch.
But does equity release now provide a good solution for pensioners who are asset rich, but cash poor?
How does equity release work?
Before I talk about that in more detail, let's have a quick recap on how equity release schemes work:
There are two main types: lifetime mortgages and home reversion schemes.
A lifetime mortgage allows you to release part of the value of your home as a cash lump sum. Normally, interest rolls up on the mortgage until you die (or move into a care home). The cash released plus interest is then repaid to the lender in full using the proceeds when the property is sold.
The second type -- a home reversion scheme -- allows you to sell all or a share of your property to a home reversion company at a pretty hefty discount in return for a cash lump sum. On death the property is sold and the company receives its share of your property. The remainder -- if any -- is available to your heirs.
There's a vast quantity of cash locked up in property. Prudential estimates homeowners aged 65 and over have more than £726 billion of equity in their homes, so why not tap into it? Well, releasing equity still isn't cheap.
How much will a lifetime mortgage cost you?
Imagine you want to use a lifetime mortgage to release £50,000. Interest rolls-up on that sum for the rest of your life. Let's say the interest rate on your lifetime mortgage is fixed at 6.39%. After 5 years, you'll owe the lender over £68,000. After 15 years, this would compound to almost £127,000 -- that's well over double the original cash sum!
And the longer you live, the more you'll have to repay. Who knows how much the sum you released and interest on top will eat into the value of your home when it's eventually sold? It could wipe out the value entirely.
So make sure you choose a scheme with a `no negative equity guarantee' which means you'll never owe more than your home is actually worth.
You can keep your costs down by setting up a flexible drawdown facility. Here cash can be taken in phases, so you only pay interest on the amount you actually use. The reserve you set up is based on the current value of your property, so it makes sense to act sooner rather than later when house prices are falling.
How much will a home reversion scheme cost you?
A typical home reversion scheme might allow you to take a maximum of say 40% of the value of your property as a cash lump sum at the age of 65. But to release 40%, you'll actually have to sell a 100% share in your home to the reversion company. (Remember with these schemes, the older you are the more you'll be able to release.)
In this case, if your property is worth £200,000, the maximum amount you can release is just £80,000. But because you haven't retained a share in your home, there is nothing left to pass onto the next generation when it is sold.
So you can see why lifetime mortgages and home reversion schemes can be costly. Now let's look at downsizing.
Downsizing your home
I prefer downsizing as a way of finding extra cash in retirement. Why? Well, for the simple reason that it's more transparent. You'll know exactly how much cash selling your home will generate. And -- best of all -- you don't have to sacrifice any of the property value to a lender as you would with equity release.
So -- in simple terms -- if you have a property worth £200,000 and you need to generate £50,000, you could move to a smaller property worth £150,000 and cream-off the profit (or thereabouts once you've deducted legal fees, moving costs, estate agency fees and stamp duty if applicable).
Better still, if you wish to leave a legacy to your family, you'll still have the value of your new property to pass on.
But, hang on a minute...who wants to sell-up when prices are falling? Nationwide say house prices have dropped 10.5% over the past year alone. And, as the housing market slows, there's no guarantee that a buyer will be prepared to pay your asking price.
Ask yourself - do you really want to move to a smaller property or would you rather stay in the home you love? If you do, then downsizing may not be for you.
From a purely financial perspective, my opinion is still that downsizing is normally a better bet. But if you're keen to stay put and you think equity release could work for you, please speak to an independent adviser who specialises in this area. Equity release is very complex and there are lots of different plans on offer. An adviser will help you find the right one.
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