Equity release: what is compound interest?
Last reviewed 24th October 2024 by the SunLife Content Team
5 min read
When you release equity with a lifetime mortgage, interest is charged to both the loan and any interest that has already been added. So, if you aren’t making repayments to cover the interest, the amount charged will get bigger every time. This is known as compound interest.
Some plans give you the option to make regular or one-off repayments. If you are making enough repayments to cover the interest added, compound interest will not build up. Instead, your amount owed will stay at the original loan amount. Find out more about Interest-Only Lifetime Mortgages.
How does compound interest work in equity release?
With the most common form of equity release, lifetime mortgages, you usually don't have to make any repayments during your lifetime. Depending on your plan, interest is added to your amount owed on a monthly or yearly basis.
Interest is calculated as a percentage of the total amount owed – the original loan amount, plus any interest that has been added previously. This means 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 (MER) | Interest added | Balance at the end of year |
|---|---|---|---|---|
| Year 1 | £81,703 | 6.74% | £5,681 | £87,384 |
| Year 2 | £87,384 | 6.74% | £6,075 | £93,459 |
| Year 3 | £93,459 | 6.74% | £6,497 | £99,956 |
| This continues throughout the life of the plan | ||||
| Year 15 | £209,360 | 6.74% | £14,555 | £223,915 |
(MER) = Monthly Equivalent Rate
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, interest will be capped so 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’. Your financial advisor will be able to confirm whether your chosen plan includes this feature.
Some plans have ‘inheritance protection’ which lets you 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. But, it will reduce the amount of equity you can release.
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:
Make repayments
With a lifetime mortgage, you may be able to make regular or one-off payments to reduce your total amount owed. 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 tell you how much you can repay each year without incurring early repayment charges.
Say, for example, Joe released £81,703 with a fixed 6.74% MER interest rate. With no repayments made, the amount owed at the end of 15 years would be £223,915.
If he repaid £250 per month, compound interest would build more slowly. So, after 15 years he would owe £146,440. By that time, he would have made £45,000 in repayments, so the total cost of borrowing would be £191,440.
This would mean a net interest saving of £32,475.
The data is as follows:
- Making no repayments. Initial loan amount, £81,703. Interest accrued, £142,212.
- Repaying £250/month. Initial loan amount, £81,703. Interest accrued, £64,737. Repayments made, £45,000.
Source: Key Group
You could also consider an interest-only lifetime mortgage. This form of equity release involves making 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
Lifetime mortgages mostly fall under either drawdown or lump sum (also called ‘Roll-up’) schemes. With lump sum plans you release your funds all in one go, so the compound interest starts 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 £81,703 in one go, he could end up accruing more interest than if he released £51,703 in year one, £15,000 in year five, and another £15,000 in year ten. (Assuming the interest rates are the same in both cases, and he made no repayments).
Source: Key Group
Interest rates can differ between Lump Sum and Drawdown plans, so your financial advisor will 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, but still 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 other options available to help you finance your retirement. These include:
- Later life mortgages
- Downsizing
- 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 circumstances and needs, and to talk you through the 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, make sure to tell your financial advisor so they can recommend the right plan for you.
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