The subject of equity release and compound interest is one you need to be aware of, especially when considering a lifetime mortgage. As the term suggests, regular interest on your loan is not repaid simply added to your outstanding balance. Over time, you will pay interest on interest hence the term compound interest.
The impact of compound interest can be significant, and therefore it is very important to take advice on the advantages and disadvantages of lifetime mortgages.
What Is the Real Impact of Compound Interest?
The best way to show the real impact of compound interest is to give you an example.
- Equity release: £50,000
- Annual interest rate: 4%
To simplify the scenario, you will assume that interest is added at the end of each year, and then interest is charged on the enhanced balance.
So the figures for a 10-year equity release will be as follows:-
|Year||Start Balance||Interest||New Balance|
If the interest was paid annually, and not deferred, then over a ten year period you would pay £20,000. As you can see from the above, the impact of compound interest means that by the end of year ten you have accumulated interest of £24,012.
This equates to an additional £4012 as a consequence of the interest rate compound formula. If interest is added on a monthly basis, then the additional compound interest charge would be even greater.
What Are the Benefits of Compound Interest?
When looking at a lifetime mortgage, there are many different factors to take into consideration.
It may well be that the homeowner has seen a reduction in their regular income and would not pass a traditional mortgage affordability test for a remortgage/equity mortgage.
Therefore if looking at a lifetime mortgage as opposed to a home reversion scheme, there is no other option. If cash flow is an issue, then the homeowner may also struggle making regular interest repayments hence the need to roll-up interest.
Potential Capital Appreciation
If you take out a lifetime mortgage aged 50 then yes there will be a significant element of compound interest, but hopefully, there will also be long-term capital appreciation on the value of your home.
In a perfect scenario, the increase in appreciation would far exceed the impact of compound interest and leave you in a net better off situation.
What Interest Rate Should I Expect on a Lifetime Mortgage?
This is a very interesting subject because historically there has been a significant premium on lifetime mortgage interest rates compared to their traditional counterparts.
However, the changing demographic in the UK has seen a greater demand for equity release services for older homeowners; hence this premium has reduced.
At the time of writing the average lifetime, mortgage interest rate stands at around 4.91% compared to average mortgage rates of between 3% and 4%.
Many experts believe there will be further downside to this figure as demand for such services increases.
What Is the Duration of a Lifetime Mortgage?
Unlike traditional mortgages, a lifetime mortgage is an open-ended term which is dependent upon either the homeowner passing away or moving into full-time care.
Any of these events would prompt a sale of the property, repayment of the lifetime mortgage with compound interest and return of surplus to the homeowner/executors.
So, it is not inconceivable that a lifetime mortgage was taken out when aged 50 could have a 25 year plus duration. It is also worth remembering that the homeowner will live rent-free in their home until a sale of the property is triggered.
Should I Take Advice on a Lifetime Mortgage?
It is highly advisable to take advice when seeking any type of property equity release. There are a number of different options, some of which will suit younger homeowners and some older homeowners.
It is also useful to be aware of the pros and cons of each option and how they might impact your long-term finances.
Independent Broker or Tied Broker?
As the term suggests, an independent broker has no formal ties with anyone or group of lenders. A tied broker will be limited to one or a group of lenders with whom they can transact.
The natural assumption is to expect an independent broker to be more competitive because they have a wider range of parties to negotiate with. Not always the case.
A tied broker will likely be a specialist in particular areas/scenarios and therefore have close relationships with lenders in these areas.
As a consequence, due to the potentially high flow of business they can pass to their tied partners, they may be able to negotiate terms which are as competitive if not more competitive than their independent counterparts.
Generally speaking, you might expect independent brokers to be more competitive, but this is not always the case.
Can I Release Additional Equity?
Let’s say, for example; you had a mortgage-free property worth £200,000. Initially, you took out a lifetime mortgage for £20,000, leaving a balance of equity in your property of £180,000.
Now let us assume that you wish to take out an additional £50,000 via another lifetime mortgage. In theory, this is possible, but it will depend upon your lifetime mortgage provider.
In the event that you had more than a one-lifetime mortgage, each one would be repaid on the sale of your property together with compound interest.
The issue of compound interest is one that you need to be aware of if looking towards a lifetime mortgage where your interest will be rolled up in a compound interest transaction.
As we have shown in the above table, even over a relatively short ten year period, you would pay an additional 20% interest – and this is on annual interest as opposed to monthly interest.
It is strongly recommended that you take advice from a mortgage broker before signing up for a lifetime mortgage.
How Can Equity Tree Help?
Here at Equity Tree, we have partnered with some of the UK’s leading Equity Release broker companies.
They have already helped thousands of people release equity already, and they can do the same for you.
Choosing an independent adviser means they won’t recommend a scheme unless they are sure it is in your best interests. Their advice is also regulated by the FCA, which gives you an additional layer of protection.
If you would like to speak to one of these equity release companies, click on the below and answer the questions.