There are two types of Equity Release; Home Reversion Plans and Lifetime Mortgages. Home Reversions involve a change of ownership of the property and so there is no debt to pay off. However, Lifetime Mortgages are mortgages on the property which are designed to run for the life of the borrowers. If they are repaid in circumstances other than the death of the borrowers, entry into permanent long-term care or moving home and transferring the loan, a penalty ‘early repayment charge’ can apply.
Penalties are designed to reflect a potential loss to the lending company by paying them back earlier than expected.
There are two methods of calculating an early repayment charge: a fixed amount that is quantified from outset, or a ‘Gilt’ linked early repayment charge.
Fixed Early Repayment Charges
A fixed early repayment charge will usually be a set percentage of the original loan amount, e.g. 5% for a five-year period. Some will then reduce to just 3% for the next 3-5 years. Some plans have higher fixed charges, for longer. After a given time, no penalty would ever be payable in any circumstances. The penalty cash amount is therefore known from day one and carries a high degree of certainty: pay the loan back early, and pay a fixed penalty.
Gilt linked Early Repayment Charges
Gilts are UK Government bonds issued by HM Treasury. They are effectively promises to pay back loans made to the Government at the end of a certain time. Historically, the edge of certificates issued were gilded, which is why they are known as ‘gilts’.
They are sold and bought in blocks of £100. The purchase price of a gilt depends on demand for them caused by general investment market conditions; whether the gilt is close to its ‘redemption’ (pay back) date and the yield or interest rate the gilt offers to investors. The price per £100 of gilts purchased can vary over time, and it is this variation that can cause an early repayment charge.
This depends on the movement in the price of a given Gilt between the date the plan is taken out, and the date it is to be repaid early. The theory is that if the price of the associated gilt has fallen since the plan was taken out, then the lender will suffer a loss if it lends the repaid loan to someone else. However, if the price has gone up, they will arguably be better off lending the repaid money to someone new at a higher interest rate, so no early repayment penalty would be payable. Sometimes a ‘benchmark’ interest rate is used, which is the actual gilt price plus a small margin of say 0.3%.
The actual gilt associated with a lifetime mortgage is notified in the offer of mortgage document. Quite often this will be something like a 15-year gilt, the price of which can be seen in the Financial Times or by searching online for the specific gilt name.
Which Early Repayment Charge Method is best?
Gilt based early repayment charges are less secure than fixed penalties as they can be variable, or equally could be nothing at all. It all depends on how the gilt price has moved. For borrowers who took out plans with gilt linked penalties say 8-10 years ago, they will have seen gilt prices plummet between then and now. Those borrowers could face potentially huge penalties if they try to pay the loan off early, for example by refinancing their loan.
However, fixed charges mean that repaying the loan early during the charge period will definitely incur a penalty. For gilt linked penalties, an upward movement in gilt rates between starting the plan and paying it off will negate any penalty.
There is nothing fundamentally wrong with either method of charging for early settlement, but care must be taken if there is any prospect that a lifetime mortgage might be repaid early. Repayment on the death of the borrowers, them moving into long term care or ‘porting’ the plan to a new home mean no penalties would apply. It is only EARLY repayment that may incur a penalty charge.
As always, advice should be sought from an experienced and qualified specialist equity release adviser. Contact Andy Wilson to arrange a free no-obligation meeting to discuss your requirements and options.