In the standard residential market, the Bank of England Base Rate is the barometer that everyone watches carefully as they consider customer needs. Frustratingly, rates in the equity release market are not nearly as simple and are governed by a range of interlinked factors.
One of these is gilts or – to move away from the jargon that plagues financial services – UK government bonds. They are issued by HM Treasury, listed on the stock exchange and promise to pay the bearer a specific return at the end of a specified period. They are also arguably one of the safest assets for an investor as they are backed by the government and any default would suggest significant issues with a country’s economy.
When equity release funders are considering how to construct their investment portfolios to generate the returns they need, gilts are an important benchmark. The 15-year gilt yield reached as low as 0.16 per cent in May 2020 so other investment options such as residential property via equity release funding were arguably particularly attractive at this time from a risk and return perspective.
In September 2022, this yield leapt to 5.09 per cent as a result of the uncertainty around the mini Budget. Whilst yields have fallen to 3.73 per cent in January 2023, they are still fairly high relative to recent history. For equity release loans to be an attractive investment, they need to offer returns above these rates and indeed above rates offered by other assets that offer similar longevity hedging benefits e.g. long dated corporate bonds or infrastructure.
Other uncertainties
However, equity release loans also have other investment risks associated, given embedded consumer benefits and protections that funders need to take into consideration when setting prices. Anyone who has worked in this sector is acutely aware that house prices can go up and down, so funders also need to consider how to price in the risk of the underlying asset not performing. This pricing is made more complex by the fact that they don’t know when the equity release mortgage will be repaid and a no-negative equity guarantee needs to be factored in.
Given the current volatile market and the fact that equity release can take eight to twelve weeks to complete from the point of application, any changes in the rate environment etc over this period also need to be legislated for within the pricing – and we know how fast things can change with the chaos around the mini-budget a perfect example.
Funders will use a variety of strategies to hedge – or manage – these challenges but these approaches used to mitigate risk also come at a cost which needs to be recovered through the rate offered. Given all the complexities and unknowns that equity release lenders need to deal with it is unsurprising that we have seen rates increase – sometimes more – than the corresponding changes in the gilt rate.
Assessing the environment
So where does this leave those of us who are speaking to clients if we can’t rely on the gilt market as an indicator for where lifetime mortgage (LTM) rates are heading or predict the long-term performance of the housing market?
Fundamentally, we should be removing the rate crystal ball from the process and instead focus on personalised advice based on the environment that we are faced with today. Each customer’s individual goals and needs, both long and short-term, should be taken into consideration and all options – including a range of later life lending products beyond just equity release – considered.
However, when advising in this environment we should also be making customers aware of the flexible features offered across modern LTMs. In a higher interest rate environment, it is particularly important that customers make use of the ability to serve interest and/or to make ad hoc capital repayments. Assuming disposal income allows, repayments will help mitigate the impact of compound interest which is also important if the benefits of fixed early redemption charges (ERCs) are to be used down the line.
With some products seeing ERCs disappear completely in as little as eight years, LTMs no longer have to be a product for life. As long as the outstanding balance is managed, remortgage opportunities can be explored in the future.
Get used to higher rates
As to when rates may come down in the equity release sector?
If I was forced to make any predictions, I would suggest that we will see economic stability return through the course of the year which will create an environment where competition for equity release assets among funders builds and rates start to fall slightly.
However, advisers and customers need to re-condition themselves to an environment that won’t see rates return to the levels enjoyed in 2021 or the early part of 2022 any time in the foreseeable future.
Our job as advisers is to give confidence to customers and, if equity release is the right option for them now, help them to proceed in the knowledge that the products are flexible enough to evolve as the market conditions and customers’ circumstances change.
