How is interest calculated on Equity Release?

Understanding how the interest is calculated on an Equity Release plan is crucial if you are going to seriously think about taking one out. By far, the most common type of Equity Release plan is a “Lifetime Mortgage”, and the amount you will owe on an Equity Release Lifetime Mortgage plan is most commonly calculated by “rolling up” the interest.

If you have ever used a savings account you will already be familiar with the principle of “rolling up” interest as it is the way interest is added to your balance to make your savings grow. With your savings, interest is added to the amount you have saved, and then as time goes on more interest is added not only to the original amount saved, but to the interest previously added as well.

Some people maybe more familiar with the term “compound interest” when it comes to describing your own savings.

The same principle is true when borrowing through an Equity Release Lifetime Mortgage where the interest is “rolled up” or “compounded”, as payments are not required. This results in the amount owed increasing over time. 

In short, the starting point is the cash you have taken from your Equity Release plan, this may include any advice, legal and application fees that have been deducted from the amount borrowed. Some lenders will allow you to add fees to their maximum amount, so the initial figure can be higher than what you requested. This initial figure is sometimes called the “Principal amount”. The way “roll up” of interest works is that interest is calculated daily. It is then added up and compounded into the outstanding balance at the end of each charging period. This is repeated for each interest charging period throughout the life of the Equity Release plan.​

The most obvious feature of rolling up the interest in this way is that interest will be calculated and charged on interest. This means that the total amount that you owe will grow at an accelerating rate with each charging period adding more in interest charges to the outstanding loan than the previous one.

The interest rate is fixed so any illustration you are given showing how much you will owe at any given time in the future can be relied upon as being accurate.

The compounding period used by Equity Release providers can either be monthly or annually. This means that two different providers which appear to be charging the same interest rate will show different outstanding amounts owing after exactly the same periods of time. The two illustrations below show the difference between an Equity Release plan that has interest calculated and added annually and one that has interest calculated and added monthly.

Roll up of interest added annually:

This shows how the amount paid to you, the interest, and any fees that may be charge mount up over 19 years. Its has been calculated using the illustrative interest rate of 2.89%. Interest is added to the amount you owe annually.

Remember, the mortgage could run for a longer or shorter time than 19 years, and if it runs longer, the amount you owe, will carry on increasing.

Roll up of interest added monthly:

This shows how the amount paid to you, the interest, and any fees that may be charge mount up over 19 years. Its has been calculated using the illustrative interest rate of 2.89%. Interest is added to the amount you owe monthly.

Remember, the mortgage could run for a longer or shorter time than 19 years, and if it runs longer, the amount you owe, will carry on increasing.

As you can see, both providers are charging an interest rate of 2.89% yet, after 19 years, the provider that calculates and adds the interest on a monthly basis shows an outstanding balance of nearly £1000 more.

Is 2.89% The Current Interest Rate?

Current interest rates (as of September 2020) can be found at that rate. The above figures are for a modest £60,000 release. Given the current market, where sums in excess of £250,000 to repay mainstream residential mortgages are common, then the differences will be magnified. Historically, lifetime mortgage rates have been as high as 10% and it is only recently that rates have fallen below 5%. There is every reason to examine your existing plan to reduce the effects of compound interest over time.

More recent plans will allow you to make a regular or ad-hoc lump sum payments of interest and/or capital in order to reduce the amount of interest charged. If you choose to make any repayment, you will be given a new illustration that will take this into account. You could incur early repayment penalties if you exceed any annual payment allowances. Some historic plans do not make any allowances for repayments. Look at your illustration sections 13 and 14 to see what criteria will be applied. It is a complex area, so please check with a qualified adviser or direct with the lender before making any repayment.

 

There are many factors you need to consider before deciding to proceed with an Equity Release plan, the interest rate and how it is calculated just being two of them. It is unlikely that you will choose an Equity Release provider solely on the interest rate being charged either monthly or annually, but it is important that you are aware of the differences between these methods of calculation and you should discuss it with your professional adviser.

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