Mortgage choices in retirement
14 Nov 2018 - Estimated reading time: 5 minutes
Background to the market and recent changes
In March of this year, the Financial Conduct Authority (FCA) amended its Handbook Glossary of Definitions and MCOB to give a more specific definition to interest-only mortgages that are taken out by those in retirement. This has allowed a new product to enter the lending market: the Retirement Interest-Only (RIO) mortgage. This product has slightly different features to those in the standard Interest-Only (IO) mortgage market and also may be considered instead of equity release mortgages, so it’s worth taking a look at these options and how the different products can affect an individual’s finances in the long-term.
The RIO mortgage has two key differences with standard IO mortgages: firstly, there is no age limit on the maturity of the loan. Many standard IO mortgages will specify that they must end before a certain age, e.g. 75, however RIOs can continue to be held to any age. Secondly, and probably more importantly, a RIO does not have the usual requirement of a credible savings vehicle alongside it – instead, the expectation is that the loan will be repaid on the death of the borrower (or at the point of moving into long term care), funded by the sale of their home. To qualify as a RIO, most providers have a minimum age of 55.
It is expected that RIOs will appeal to those who already hold IO mortgages that are approaching maturity though currently have no repayment vehicle agreed and no way of paying off the capital owed. As of May 2018 some 30,000 borrowers1 exist in the UK mortgage market that will, in the coming years, require a means to transfer this debt and RIO mortgages could be the solution they need. For this group in particular, this means that RIOs may be seen as an alternative to Equity Release Mortgages (ERM) and so it is useful to consider how the payments made by a customer might stack up under the two different types of product.
Comparison on the financials
Let’s consider a recent retiree at 65 years old who is aiming to borrow £50,000 against the value of their home, which is currently worth £200,000 (meaning an LTV of 25%). Taking a representative product from each mortgage type, we can estimate the cost difference that these might provide in the next few decades.
A sample RIO has a 3-year fixed rate of 3.69%, followed by a 2-year buffer period with a reduced Standard Variable Rate (SVR) of 4.69% and following this an SVR of 5.69%.
The average rate in the ERM lump sum market is a fixed rate of 4.87%*. The amounts paid back will vary depending on how long the customer lives for and the results over 10, 20 and then 30 years are detailed in the table below:
(Click the image to expand)
Note that the figures in the table above do not allow for the time value of money, so no discounting has been applied
Looking at the 10, 20 and 30 year differences in amount payable, it is clear that if servicing monthly interest payments is an option then a RIO mortgage is a very competitive product for customers looking to borrow a lump-sum as the compounding interest on the ERM grows very quickly. However, as part of the RIO application process the customer is subject to checks of their income and not everyone will pass these and be eligible for this type of borrowing.
There are further factors that will need to be taken into account when weighing up the decision between RIO and ERM. With variable interest rates, comes a great deal of uncertainty and RIOs are no exception. After the fixed term of 3 years, the loan reverts to an SVR which many customers will look to improve upon by transferring the loan to another deal with a new fixed rate, which means that they will be subject to the market conditions at that future time. Additionally, since RIOs require an assessment of income, if a customer’s financial situation has changed in the time since taking the original RIO they may struggle to find a provider willing to take on their debt.
It is difficult to predict the direction of the rates on offer, especially given that RIO mortgages are so new. With the entry of new lenders and their RIO products, it is possible that the fixed rates available on these might fall due to competition. However, it is also likely that base rates will increase given that they are already at an all-time low. The outlook for interest rates on equity release products is also uncertain, with expectations that they may increase from the current low levels. A key development which could affect this outcome is the recent Prudential Regulation Authority (PRA) guidance on Capital Requirement Regulation firms, which may lead to ERMs becoming more capital intensive, and perhaps less appealing, for lenders to provide.
Therefore, customers should be advised carefully on the options afforded to them and their benefits/shortfalls. At the present time, those advising on RIOs do not require a specialised qualification to do so (ERM advisers do require this). Since RIO holders pay monthly interest whilst ERM holders “roll up” interest, RIO customers must submit to an income assessment to determine whether they will be able to meet monthly interest repayments, and so there needs to be regulation put upon advisers to ensure customers are receiving all of the appropriate information they need to make the right decision on borrowing. The FCA is also keen to ensure that the implications for an individual on tax and means tested benefits are fully understood.
What happens next for this market?
The ERM market has seen a shakeup because of change in regulation, and the arrival of RIOs. We have seen product options double from 2016 to August 2018, and one of the more interesting ERM products available are of the drawdown variety: these allow customers to release smaller portions of equity over time, which provides flexibility and reduces the build-up of interest since this is only charged on the amount withdrawn at any given time. The appearance of RIO mortgages hasn’t stopped growth in the ERM market, though it may well have slowed it. The number of ERM policies in-force grew 9% over the past 6 months (vs. ~18% the previous half-year2), despite diversification of the product offering including drawdown ERMs, and flexible interest/capital repayment options. Could we see RIO mortgages take over this section of the lending space? Only time will tell.
*rate as per the ERC Autumn Report issued September 2018
2 https://www.equityreleasecouncil.com/document-library/equity-release-market-report-autumn-2018/ (page 6, "Trends in equity release customer numbers".