Equity release: what is compound interest?
Last updated 27th July 2023
5 min read
With equity release products such as lifetime mortgages, you don’t need to make any repayments during your lifetime (unless you choose to). Over time, interest will be charged to both the loan and interest that has already been added, meaning the amount of interest charged will get bigger every year. This is known as compound interest.
How does compound interest work in equity release?
With the most common form of equity release, lifetime mortgages, there are usually no repayments required until you die or move into long-term care. Depending on your plan, interest will either be added to your amount owed every month, or on a yearly basis.
Interest is calculated as a percentage of the total amount owed – the original loan amount, plus any interest that has already been added previously. This means that even if the interest rate is fixed, the actual amount of interest added will increase over time.
To use a simple example – say Joe borrowed £100 and was charged 10% interest every year.
In year one, the interest added would be 10% of £100, which is £10. Now his amount owed is £110.
The next year, the interest added would be 10% of £110, which is £11. Now his total amount owed is £121.
An example of how compound interest could accrue on equity released with a lifetime mortgage
|Year||Balance at start of year||Interest rate||Interest added||Balance at the end of year|
|This continues throughout the life of the plan|
Source: Key Group
What happens if the amount owed exceeds the value of my home?
Nowadays, almost all equity release plans come with a ‘no negative equity guarantee’. This means that even if you live a very long life, compound interest will be capped so that the total amount owed never exceeds the value of your home. So, your loved ones will never be left with debt from your released equity.
If, when you die or move into long-term care, your home sells for less than expected, most equity release providers will still write off any remaining balance.
If your equity release provider follows the standards set by the Equity Release Council, they will have a ‘no negative equity guarantee’. Otherwise, your financial advisor will be able to confirm whether your chosen plan includes this feature.
Some plans feature ‘inheritance protection’ which allows you to ring-fence an amount or percentage of your property value that cannot be eaten into by compound interest. This way, you can guarantee to leave something to your loved ones from the sale of your property.
How can I reduce or avoid compound interest?
If you want to make sure you can leave some inheritance from the sale of your home after you die, you might want to take steps to prevent compound interest from building up too quickly on your equity release mortgage.
There are a number of ways to reduce or avoid compound interest:
With a lifetime mortgage, you may be able to make regular or one-off payments to reduce your total amount owed. Doing this will mean less interest is added over the lifespan of your mortgage, so the final amount owed will be less. Your financial advisor will let you know how much you can repay each year without incurring early repayment charges.
You could also consider an interest-only lifetime mortgage. This is a form of equity release where you make monthly repayments to cover the interest on the loan. With these plans, you are paying off all the interest so the total amount owed never grows, and you know exactly what will be left of your estate when you pass away.
Drawdown versus lump sum
Equity release plans generally fall under either drawdown or lump sum (also called ‘Roll-up’) schemes. Lump sum plans allow you to release your funds all in one go, so the compound interest begins to build on day one.
Drawdown plans allow you to release parts of your maximum amount bit by bit, as you need it. Interest only builds on what has been released.
For example, if Joe released £50,000 all in one go, he could end up accruing more interest than if he had released £25,000 in year one, and £25,000 in year five (assuming the interest rates are the same in both cases, and he made no repayments).
Interest rates can differ between Lump Sum and Drawdown plans, so your financial advisor will run through the pros and cons of each and help you decide which option would fit your needs best.
Home reversion plan
A home reversion plan is a form of equity release where you sell all or a portion of your home for an agreed price, but still have the right to live there until you die or go into care.
Because home reversion is a sale rather than a loan, there is no interest accrued. But it is worth noting that you sell a percentage rather than a fixed amount. So the amount repaid from your estate could end up being more than the amount you sold it for.
Alternatives to equity release
Equity release isn't right for everyone, and there are a number of other options available to help you finance your retirement. These include:
- Later life mortgages
- Moving to a less expensive area
- Using existing assets, shares, or savings
- Seeking financial support from friends and family
Find out more about alternatives to equity release.
Speaking to a financial advisor
Anyone looking to release equity will need to speak to a financial advisor. The advisor will take time to understand your unique circumstances and needs, and to talk you through the various options available to you.
If you’re worried about compound interest, or want to ensure you can leave some inheritance from the sale of your property once you’re gone, make sure to tell your financial advisor so they can recommend the right plan for you.