How does equity release compound interest work?

What is compound interest on equity release?

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When you take out a lifetime mortgage, each month or year the lender adds interest to both the loan and interest already owed. This can build up significantly via compound interest, so it is important that you understand how it works.

You will need to consider the effect of compound interest when deciding whether equity release is right for you. In this article, we explain how compound interest on equity release works. We have also included a link to our equity release interest calculator.

Here is what we cover in this article:

• Compound interest on equity release: how does it work?
• How do equity release lenders set their interest rates?
• How can compound interest affect you?
• How can I reduce the amount of equity release compound interest?
• Get your personalised equity release quote.

We hope this article will help you understand equity release and compound interest, but more help is available through Equity Release Wise. Our selected advisers can provide information and advice, and competitive quotes from leading UK providers. 

Just call us on 0808 178 3055 or request a call back and we’ll arrange a no-obligation appointment with an adviser for you. Alternatively, check your eligibility and get an initial indication of how much tax-free cash you could unlock.

Compound interest on equity release: how does it work?

Compound interest on a lifetime mortgage (the most popular type of equity release plan) differs from some other forms of compound interest. You should therefore ensure that you understand it as part of your decision-making about taking out an equity release plan.

With typical standard residential mortgage interest, lenders charge interest only on the original loan amount. But with a lifetime mortgage, the equity release provider charges interest on the amount you borrow (the loan ‘capital’ or ‘principal’) PLUS any interest that has already accrued. 

Interest accrues until the end of your lifetime mortgage. At this time, your home is sold to repay the loan and interest owed. This will typically be when you pass away or move into long-term residential care, although you will have the option of paying off the loan before then. 

Some lenders start adding interest to your loan after the first month, while others start after the first year. From then on, the lender adds interest to the original loan amount PLUS the accrued interest each month or year.

How do equity release lenders set their interest rates?

Equity release providers link their interest rates to a number of economic factors. This includes the current price of government bonds and the return on them (known as gilt yields). They also consider potential future changes in gilt rates, as well as possible changes in property values.

For more information about how interest rates work please see our guide to equity release interest rates.

How can compound interest affect you?

Typically you don’t make any monthly repayments to  pay off any of the lifetime mortgage or interest. As a result, the amount owed to the lender can grow significantly year-by-year.

This means that equity release can be an expensive way of borrowing compared to other forms of loan. The result of this is that the amount owed may be much more than the original loan amount when you pass away or move into long-term care. 

This will potentially have a big effect on how much you receive after the sale of your house if you go into long-term care, or on your family’s inheritance if you pass away. However, you may feel this is not a concern because you don’t have to worry about making any monthly repayments.

Example of equity release compound interest 

Let’s look at an example of how compound interest on equity release works. In this example, someone releases £75,000 of their home’s equity with a lifetime mortgage, at an interest rate of 5%.

After one year, the amount owed would be the original £75,000 plus interest of £3,750, making a total of £78,750.

At the end of year two, the amount owed would be £78,750 plus 5% of that amount – a total of £82,687.50. The process continues until the lifetime mortgage is repaid.

The factors that affect how much will be owed at the end of the lifetime mortgage are:

• The amount borrowed. Interest is charged on how much money you have released, either as a lump sum or through drawdown payments over time.
• The interest rate. Lenders usually fix the rate when you take out the lifetime mortgage, although variable rate plans are available. To see some of the latest interest rates, please visit our equity release interest rates page.
• How long the lifetime mortgage runs for. It is of course impossible to know in advance how long this will be, as none of us can know when we will pass away or move into long-term care. 

Why not use our equity release compound interest calculator to work out how much interest might be involved for the terms you are considering?

Or for quotes showing the interest you can expect to be charged by different equity release providers, call us on 0808 178 3055 or request a call back. We’ll arrange an appointment with one of our selected advisers to give you all the information and advice you need.

How can I reduce the amount of equity release compound interest?

It is possible to reduce the amount of compound interest that accrues on your equity release plan – or even to prevent any interest from building up. Here are some ways to do it:

Take out an interest-only lifetime mortgage. These products let you make voluntary interest payments each month. You can pay some of the interest each month to reduce how much compound interest builds up. There is also the option of paying the full interest each month, in which case no interest at all will accrue on the loan.

With some interest-only plans, the lender gives you the option to stop making the interest payments at any time. If that happens, compound interest will then be charged in the usual way. In effect, your plan will convert to a standard lifetime mortgage with no further option to make regular interest payments.

Pay off some of the loan early. Lenders typically allow you to pay off up to 10% of the loan amount each year without penalty. If you pay off more than the penalty-free level, you can expect to pay an early repayment charge. You can read more about paying off equity release early.

Choose a drawdown lifetime mortgage. With these plans, you take an initial lump sum followed by further cash releases as and when you need them. The advantage here is that   interest is only charged on the money you actually release, and not on the total sum available to you.

Read more: Can I do equity release without compound interest?

Get your personalised equity release quote

To find out whether equity release could work for you, and to get quotes from leading providers to help you choose the best option, call our friendly team on 0808 178 3055. They can connect you to one of our carefully selected advisers who can answer all your questions, check your eligibility and get personalised quotes.

Alternatively, you can also request a free call back here or get a free quote and an initial indication of how much tax-free cash you could unlock.