I suppose the best place to start is explaining what and how compound interest works in the UK. In its simplest explanation its interest being charged on interest. That is, after the first years interest is charged, the seconds years interest is charged on the new higher balance.  And the third years interest charged is charged on the second years higher balance…. and so on.

For example, if you release £50,000 and the first years interest is £1,500 then in year two you are charged interest on £51,500 and not £50,000.  Year two interest would then be circa £1,545 and thus added to the balance so in year three interest is charged on £53,045 ….. and so on throughout the years.

With residential mortgages you are making contractual payments on a monthly basis.  A lifetime mortgage however is typically paid back on death or entering long term care.  So rather than making any monthly payments the initial amount borrowed plus interest rolls up hence “compound interest.”

Different lenders then charge this interest slightly differently.  Some on a monthly basis (MER) and some on a yearly basis (AER).

With any Equity Release case it is important you know and understand how compound interest works.  The higher the rate, the quicker and bigger the initial balance rolls up.  As Lifetime mortgages are generally repaid on death a realistic look at life expectancy is also required.  You may need to look 20/30 years plus into the future.

One good thing to bear in mind is that most Lifetime Mortgages have fixed rates so if all you borrow is an initial amount you will know exactly what the balance will be in future years.  Regardless of what happens with interest rates you are safe in the knowledge that your fixed rate will never increase.  This is where a uk compound interest calculator can help.

Above is an example of some of the paperwork you will receive.  This is based on a release of £15,000 fixed at 4.48% (MER).  As mentioned above, it shows the interest rate being charged on the revised balance however you are fully aware of what the balance will be and there will never be any nasty shocks regardless of what happens to interest rates in general.

Is there a way to reduce the interest compounding on a lifetime mortgage?  Short answer is yes!

Most lenders allow you to make ad hoc payments towards the amount borrowed if you so desired.  It’s important to point out here that repayments are not required on a lifetime mortgage and it is purely a personal choice.  Most lenders and products however allow you to make payments of up to 10% of the initial loan penalty free.  Some products will allow up to 20% and some up to 40% of the initial amount.  These can be great if you are looking to pay the mortgage back over a period of time penalty free.  There is no contract in place to make these payments and it is again personal choice.  Some customers like the idea of this option in order to control the compounding interest being added every year.  This could be a one off payment or regular payments.

With interest rates around the lowest they have ever been having the ability to make these payments would allow you to ….

• Repay some of the interest
• Repay all of the interest and keep the balance the same
• Repay all of the interest and chip away at some of the capital

As you can see, having the option of making these ad hoc payments is a powerful feature of reducing the compounding interest.

Another way to limit the amount of interest rolling up is to have a drawdown lifetime mortgage.  This is where you take the amount required now, and drawdown on the remaining amount as and when required – subject to the amount of drawdown facility available.

So rather than take £70,000 now in one lump sum, you would have the option of taking, for example, £40,000 now and the remaining £30,000 as and when (and if) required.  What this means is that you are only charged interest on the initial amount taken.  This in turn equates to you only having the interest charged on £40,000 and not the full £70,000.

Its worth pointing out here that the rate will be fixed for life on the initial amount and the rate will be at the products prevailing rate (still fixed) at the time you take the drawdown.  This may be higher or lower.

A final option would be an interest only option.  This is a more traditional mortgage whereas you are contractually obliged to make the payments on a monthly basis.  Similar to a residential mortgage you would have to go through affordability checks and assessment.  Once completed you are then making the interest only payments on a monthly basis.

Hopefully this has given you a bit of a better understanding of how compound interest works on equity release.

If you would like further information on Equity Release Lifetime Mortgages in general please feel free to get in touch.  Alternatively if it’s something you have been considering then please ask us for a personalised illustration.