Over the past decade equity release has grown in popularity among older homeowners facing a shortgage of cash. But last year thousands of pensioners abandoned plans to unlock the capital stored in their homes because of concerns about collapsing house prices and the deepening recession.

As a result, the UK equity release market shrank by 20 per cent last year. It is easy to see why older homeowners are worried. House prices fell by 17.8 per cent in the past 12 months, according to Nationwide Building Society, and are expected to tumble by at least a further 10 per cent this year. Some commentators, such as Capital Economics, the consultancy, expect prices to fall by another 20 per cent.

Equity release brokers insist that this is no reason to delay unlocking capital in your home. But independent financial advisers say that homeowners could be right to remain cautious.

John Postlethwaite, of Punter Southall Financial Management, the independent financial adviser, says: “Equity release can be a valuable retirement planning tool but it is a gamble. The risk is that the amount of equity left in your home shrinks to nothing over the years.”

Here, we outline the types of equity release deals available and the risks if house prices fall or stagnate.

Lifetime mortgage

In the past ten years equity release providers have been keen to push the apparent safety of lifetime mortgages, which are flexible loans taken out against your home and do not have to be repaid until the property is sold. These loans can be taken either in a lump sum or as an income drawdown plan, allowing homeowners to take out cash as needed, rather than in one go.

Traditionally, lenders are cautious about the amount that you can borrow against your home. The maximum loan-to-value (LTV) ratio available for a 55-year-old homeowner is 21 per cent, according to Key Retirement Solutions, the specialist equity release adviser. For a 95-year-old, the maximum LTV rises to 51 per cent.

A £50,000 lump sum at a typical interest rate of 6.5 per cent would grow to £176,182 in 20 years. If house prices rise at the same or greater rate, this rolling-up of interest would not worry a borrower. But in a stalled market, compound interest can eat into the remaining equity in your home (see graph, below).

To protect borrowers, most members of Ship, the equity-release trade body, offer a “no-negative-equity guarantee”, so that the loan cannot grow to more than the value of your home.

Mr Postlethwaite says: “Over the long term, house prices do not generally grow at the same pace as interest rates on equity release loans. Stagnating value will mean that no-negativeequity guarantees are more valuable to worried homeowners, but the reality is that these loans could wipe out any stake that you had hoped to leave to relatives.”

Income drawdown plans reduce the effect of compound interest because the entire amount is not taken in one go. Instead, homeowners are given access to a total loan amount, but only in stages. Interest is paid only on the cash that has been used. Income drawdown accounted for 60 per cent of the equity release market last year.

A 65-year-old taking out £20,000 immediately, then £20,000 at 70 and a further £5,000 at 75, at an interest rate of 6.5 per cent, would find that the total bill at 85 was £131,295, which is £27,269 less than if he or she had taken out the full £45,000 at 65.

Robert Sinclair, of the Association of Independent Financial Advisers, the industry trade body, says: “We favour drawdown plans over other types of equity release. By taking only what you need, you limit the impact of the rolling up of interest and the margins built into a lifetime mortgage would make it unlikely that borrowers will face negative equity.”

Homeowners who are worried about the impact of falling house prices on existing lifetime mortgages should speak to an independent adviser, says Claire Barker, of the Equity Release Solicitors' Alliance. She adds: “There is a gamble to some degree, but individuals are always warned that house prices go down as well as up. Over the long term, house prices should cancel out the roll-up interest, but that is not guaranteed.”

Home reversion

The popularity of home reversion plans has dwindled in recent years as homeowners opt for the flexibility of income drawdown. Only 4 per cent of equity release deals were home reversion plans last year, against 95 per cent in 1999, when reversions were the primary product in the market.

Under the terms of home reversion plans, homeowners sell a stake in their property to an equity release provider for a fixed price and remain in the home until it is sold, usually after both partners have died.

Home reversion is incorrectly compared with controversial sale-and-leaseback schemes. Home reversion is regulated by the Financial Services Authority, unlike sale and leaseback, which is therefore more risky.

Home reversion providers do not charge homeowners rent to stay in their homes and do not have the power to try to force homeowners out of their homes - a complaint levelled against less scrupulous sale-and-leaseback operators. It is also available only to homeowners over 65.

Home reversion remains attractive to a small proportion of homeowners because of the certainty and security of the plans. If house prices rise or fall, you will keep the remaining stake in your home, which you can leave as inheritance to your relatives.

Mr Postlethwaite says: “If you take out a lifetime mortgage and the housing market stagnates over the next 20 years, you could be left with little or no equity. With home reversion, you choose the proportion that you will still own when your house is sold.”

However, there are drawbacks in the current housing market. Nigel Hare-Scott, of Home & Capital Advisers, another broker, says: “In the past year home reversion has been hit by the perception that homeowners would be selling a chunk of their property for less than it is worth. The discount on the market value has increased as house prices fall, so people are getting far less for a stake in their home than in previous years.”

For example, a 75-year-old couple in a home worth £300,000 could have raised £139,000 by selling a 100 per cent stake a year ago, under the Open Option Plan from Retirement Plus. This figure has been reduced to £130,500 today. Retirement Plus levies an application fee of £275, which is refunded on completion.

Checklist

First explore other ways to raise capital, such as interest-only personal loans or moving to a smaller property.

Ensure that your provider is a member of Ship, the trade body established to protect the interests of consumers.

Speak to a specialist independent financial adviser.

Discuss your plans with members of your family.

Consider the impact on eligibility for means-tested benefits.

Case study - Home repairs, holidays and funds left over

Edward and Cynthia Doyle, left, opted for a home reversion plan with Norwich Union in 2006, when house prices were nearing their peak. The couple sold 90 per cent of their Victorian cottage on the Isle of Wight for a £91,000 lump sum. The market value for the home was £250,000.

Mrs Doyle says: “We are pleased with the deal. Our pensions covered our day-to-day needs, but we never had enough money to enjoy ourselves.”

The couple used the money to repair the leaking roof and took holidays and have more trips planned. But they have spent only a quarter of the lump sum. Mrs Doyle says: “At our age it is harder to burn through money, but it is comforting to know that it is in the bank.”

The Doyles decided to release capital in their home, advised by Home & Capital, the broker, only after speaking to their children, aged 40 and 41.

The couple were unaware that house prices were particularly high when they chose a home reversion plan. Mrs Doyle adds: “Looking back, we timed it well.”