Compound interest explained Unless you choose to do so, there are no repayments to make on a lifetime mortgage until the plan comes to an end. As a result, a lifetime mortgage is subject to compound interest. Compound interest is different to the interest added to a residential mortgage or personal loan. How does it work?
interest already accrued), not just the amount you initially borrowed. This means a larger amount of interest is added to your lifetime mortgage every period. And this cycle continues until the plan ends. Without making payments, this can significantly reduce the equity remaining in your home and leave you with limited financial options in the future. This could mean you're unable to remortgage to a cheaper product in years to come, reduce your ability to privately fund any future care costs, or restrict your options to move home in the future.
With a lifetime mortgage, interest is added either monthly or annually depending on your plan. During that first month or year, interest is charged and added to the amount of money you’ve borrowed, otherwise known as your initial loan amount. The amount of interest added will depend on your initial loan amount and interest rate. If you’ve had a residential mortgage or personal loan in the past, you’ll know the interest added is based on the amount you originally borrowed. But with a lifetime mortgage, that’s not the case. Instead, the interest is calculated and charged on what you owe (your initial loan amount plus the
By not making payments towards your lifetime mortgage, you not only reduce the value of your estate, but also restrict your financial options in the future; with less equity to draw from should you need it. With that in mind, it’s important to consider both your current and long-term needs and circumstances before choosing whether to go ahead with equity release. And if you decide a lifetime mortgage is right for you, it’s always recommended to make payments towards your loan to help reduce the impact of compound interest. You can read more about how to reduce the cost of your lifetime mortgage on page 22.
The table shows the impact compound interest has on a lifetime mortgage if you choose not to make repayments. In this scenario, the customer has released £82,475 from their £288,000 home. Their lifetime mortgage accrues £5,349 of interest in the first year. In year 2, as interest is charged on the outstanding balance (£87,824), not the initial loan amount (£82,475), £5,695 is accrued in interest – £346 more than in year 1. In year 3, £6,065 is added in interest – £370 more than in year 2 and £716 more than in year 1. This cycle then continues for the life of the plan, which is usually until you or the last remaining applicant passes away or moves into long-term care. Thinking about the future With a lifetime mortgage, interest is added to the loan until it’s repaid. If you choose not to make any payments towards the balance, your remaining property equity will reduce quickly. For example, in the scenario above, the customer has over £188,000 in property equity after three years. But that reduces to less than £77,000 by year 15. And by year 20, the customer has no property equity remaining – although the customer will never owe more than their home's worth as a result of the no negative equity guarantee.
An example of how compound interest accrues over 20 years Balance at the start of year Interest (6.3% MER) 1 Balance at the end of year 2
Remaining property equity 3
£82,475 £87,824 £93,519 £198,778 £272,153
£5,349 £5,695 £6,065
£87,824 £93,519 £99,584
£200,176 £194,481 £188,416
Year 1 Year 2 Year 3
This cycle continues for the life of the plan
£12,891 £17,649
£211,669 £289,802*
£76,331
Year 15 Year 20
£0
This example is for illustrative purposes only and uses the average release amount of £82,475 and monthly equivalent rate (MER) of 6.3% – Key Market Monitor H1, 2023. Average UK house price of £288,000 – ONS, August 2023. 1. Interest rate: The rate at which interest is applied to the loan – in this case, monthly (MER). With the lifetime mortgages we recommend your interest rate is fixed for life. This column shows how much interest has been added to the loan that year 2. Balance at the end of the year: How much is owed at the end of the year, including compound interest 3. Remaining property equity: The difference between how much your property is worth and the outstanding balance of your lifetime mortgage *Although the balance at the end of the year is higher than the property's value, you'll never owe more than your home's worth with a lifetime mortgage that meets Equity Release Council Standards, thanks to the no negative equity guarantee. Read more about this on page 26.
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