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Equity Release Supermarket News What is Compound Interest and how does it work with an Equity Release Plan?
What is Compound Interest and how does it work with an Equity Release Plan?
Equity Release Supermarket News What is Compound Interest and how does it work with an Equity Release Plan?
Compound Interest & How Does It Work with an Equity Release Plan

What is Compound Interest and how does it work with an Equity Release Plan?

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Mark Gregory
Checked for accuracy and updated on 03 April 2024

One of the many questions asked by those thinking of taking out a lifetime mortgage is how much will it ultimately cost? It’s a question we get asked a lot here at Equity Release Supermarket – so we thought it best to clear things up.

Whilst calculating the maximum amount of money you can borrow from your property is relatively straight-forward, calculating what’s known as 'compound interest' is slightly more complex. But don’t worry, this isn’t anywhere near as scary as it sounds.

In this article, we’re going to explain how interest is calculated on a lifetime mortgage (the most popular type of equity release plan) and, more importantly, give you some tips on how to minimise, or avoid it altogether.

What is compound interest?

Unlike traditional mortgages, a lifetime mortgage is typically only paid back when your home is sold. Like any other type of loan or borrowing, interest is typically applied at a specified fixed rate. However, with lifetime mortgages there aren’t usually any monthly repayments to make. Instead, the interest accrues and is compounded onto the balance of the loan: hence the name 'compound' interest.

In short, compound interest works by charging interest on the total amount of the loan, including the interest that has already built up. This therefore gains momentum as the years role by.

Equity release lenders can apply compound interest in one of two different ways: monthly interest (MER) and annual (AER). The most popular method is for the interest to be calculated daily and added to the balance once a year. Aviva and Just Retirement are equity release companies that currently offer an annual rate of interest. Monthly compounding of interest examples would be Legal & General and More2Life.

A lifetime mortgage is appropriately named because it is designed for longevity and not as a way to borrow for the short-term. Compound interest by its very nature can quickly gather pace and has the potential to dramatically increase the amount owed over a long period of time. If you’re considering a lifetime mortgage, it’s essential to understand exactly how compound interest works and by how much it could reduce the value of your estate.

An example of how compound interest works

Suppose you took out a lump sum lifetime mortgage of £40,000 at 5.0% interest. At the end of the first year, the total interest would be £2,000. This makes your outstanding balance £42,000. So far, so good.

At the end of the second year, however, you will be charged 5.0% interest again, but this will be calculated on the closing balance of the previous year, which was £42,000. This makes the interest £2,100. Added to last year’s balance, this gives an outstanding balance of £44,100.

To take this one further, after 10 years the outstanding balance would be £65,155.77.

Interest charged Total outstanding balance
Year 1 £2,000.00 £42,000.00
Year 2 £2,100.00 £44,100.00
Year 3 £2,205.00 £46,305.00
Year 4 £2,135.25 £48,620.25
Year 5 £2,431.01 £51,051.26
Year 6 £2,552.56 £53,603.82
Year 7 £2,680.19 £56,284.01
Year 8 £2,814.20 £59,098.21
Year 9 £2,954.91 £62,053.12
Year 10 £3,102.65 £65,155.77

But before you frantically run off to find a calculator, you can breathe a sigh of relief: there’s no need to memorise any formulas or calculations. All you need to do is contact one of our experienced advisers, who will research the entire market and find the best rate for you. Typically, our lifetime mortgages have a fixed rate of interest, so you will always know the expected total outstanding balance of your plan.

How can I reduce the interest on a lifetime mortgage?

There are various ways that you can reduce the interest repayable on a lifetime mortgage - or avoid it altogether. Let’s look at these.

Drawdown plan

One way to limit the amount of interest you accrue is to release money as and when you need it via a ‘drawdown’ scheme, rather than in one lump sum. As well as providing you with an initial advance, a drawdown lifetime mortgage allows you to ‘draw’ on a cash facility.

For example, if you can borrow £80,000, but only need £30,000 now, you have a £50,000 ‘pot’ to dip into as and when you need to in the future – and at no extra charge. Plus, the interest rate you pay in the future will be the same as it is now.

This way, interest is only charged on the amount you have borrowed from the cash facility, rather than the full amount available to you. This means that over time, the interest is likely to be less than if you had taken it all as a lump sum.

Voluntary repayment plan

As its name suggests, these types of plans allow you to repay a percentage of your loan annually without any penalty of up to 10-15% of the original amount borrowed, as a lump sum, or series of payments.

This facilitates three scenarios:

  • Repay an amount lower than the interest charged - which will have the effect of lessening the roll-up of interest & ultimately the final balance.
  • Repay the interest charged each year to keep the balance at the same level throughout the term of the plan.
  • Repay more than the interest charged, then the balance will actually reduce over time, almost like a capital & repayment mortgage.

So, for example, if you were to come into an inheritance yourself, you have the flexibility to reduce the balance of your borrowing within the terms specified - which in turn will reduce the final amount of interest repayable.

An interest-only plan

A third way (which avoids paying any interest at all) is to take out an interest-only plan. In this situation, the outstanding balance remains the same due to the requirement to make monthly interest-only payments.

So, if you borrow £30,000 with an interest-only plan, the final amount to be repaid is still £30,000.

But don’t worry if you’re concerned that you can’t commit to making monthly interest payments for years to come. There are plans available that allow you to stop and start interest repayments as and when you want to. While taking this approach won’t avoid paying interest, it could certainly reduce it.

To find out more about how compound interest works and how to find an equity release plan that could reduce (or avoid it), speak to your local Equity Release Supermarket adviser today by calling us on FREEPHONE 0800 802 1051 for your FREE initial consultation.

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