Equity release: realising a home's true value

Last year, home owners borrowed some £1.2bn through so-called lifetime mortgages and home reversion plans. Although the sum is small when set against the overall mortgage market, it is significant because the majority of borrowers using such schemes do not have sufficient income to support a conventional mortgage.

Such equity release schemes have become popular with older home owners in recent years as a way to fund a range of expenditure, from once in a lifetime holidays and home improvements to health care.

House price inflation has also created a generation of people who may have relatively modest incomes, but have an asset that could well have doubled in value. But the conventional ways of releasing that capital - selling up and moving - is either unappealing or not practical.

According to David McGrath, head of equity release at mortgage brokers London & Country, most home owners wanting to release capital opt for a lifetime mortgage, with just five per cent or so taking out a home reversion plan.

With a lifetime mortgage, the home owner takes out a new loan secured on their property. Unlike a conventional mortgage, which is for a fixed term, a lifetime mortgage runs until the borrower dies or sells. In each case the borrower pays no interest during the term of the loan. Instead, interest rolls up, with the total repayable on the sale.

As Mr McGrath points out, as interest is compounded, after about 11 years the total debt is about double the original loan. This means that a lifetime mortgage is not a cheap proposition.

Rates are typically rather higher than for regular mortgages: Prudential currently have one of the market-leading rates, at 6.02 per cent, with interest calculated monthly.

Interest rates on lifetime mortgages are also usually fixed, and the arrangements come with a negative equity guarantee. This means that the total sum owned under the mortgage will never be more than the value of the property, even if house prices fall.

With a lifetime mortgage, the borrower keeps ownership of the property. At the end of the arrangement, if the debt is less than the value of the property, the difference can forms part of the borrower's estate in the usual manner.

Under a home reversion plan, the home owner sells the property outright to the lender at the start of the plan. The seller is then granted a lifetime tenancy in the property, but has no share in any future increase in the property's value.

With a home reversion plan, the lender will buy the property at a substantial discount to the current market price, in order to cover the cost of granting the lifetime tenancy. There are some advantages to reversion plans, however: the seller knows exactly how much they have realised from the property, and they are free to spend or gift the proceeds as they see fit.

One disadvantage is that, unlike lifetime mortgages, home reversion plans are not currently regulated by the Financial Services Authority. Another is giving up legal ownership of the family home.

Picking the best arrangement means taking some hard decisions on property prices and your own life expectancy; the suitability of each way of releasing equity also depends on age.

At London & Country, Mr McGrath says that home reversion plans are only really suitable for those in their 70s or 80s. Lifetime mortgages are available from the age of 55, although the younger the applicant, the lower the loan to value the lender will offer.

A further, and recent, advantage of lifetime mortgages is that they offer more flexibility than home reversion plans. "Three or four lenders, including Prudential, now offer some form of drawdown of the loan," says Mr McGrath. "This means you are only charged interest, as you need the money."

This sort of arrangement could well suit someone looking for funds to help with care and other costs, which tend to rise over time.