Combating compound interest on later life borrowing as interest rates rise
Rising interest rates, set to stay higher for the foreseeable future, makes the effect of compound interest more marked over time. How can this be mitigated?
Interest servicing, planned overpayments or a combination can make the use of housing equity more cost effective throughout retirement.
It pays to take an interest in repaying interest
Over the course of the last few months, interest rates for Lifetime Mortgages have risen sharply and, although they have eased off a little more recently, rates are set to continue at higher levels than those experienced up until the middle of 2022.
This higher interest rate environment presents challenges to the continued growth of the later life lending market and, rightly, raises the focus around alternatives to interest roll-up Lifetime Mortgages. The impact of accumulated compound interest on retirement and legacy household finances needs to be assessed in parallel with any immediate concerns around both cooling house price inflation and the raised cost of daily living.
The higher the prevailing borrowing costs, the greater accumulated debt will obviously be under a roll-up Lifetime Mortgage. As of April 2023, roll-up lifetime mortgage borrowing debt will double after 12-13 years compared to around 17-18 years if the borrowing had been taken out in January 20211. This change is significant and advice relating to later life borrowing needs to be as holistic, thoughtful, and considered as it has ever been.
This also means that consideration be given to alternatives to equity release and, just as importantly, if borrowing is required, what form this could take. For example, can the client’s retirement income support ways to mitigate the impact of taking on a later life mortgage? The case study which follows walks through one potential scenario.
Some options to mitigate the impact of later life borrowing
There are several options that can serve to mitigate the effect of compound interest building on debt owing from a Lifetime Mortgage.
Use a Flexible drawdown facility
One of the most straightforward ways of ensuring that the effect of compound interest is reduced is to plan to release the money from the home only when it is needed, instead of releasing it all in one lump sum.
Under a Flexible Drawdown Lifetime Mortgage, interest on the borrowing only starts accumulating from when the money is released. Any future borrowing under the drawdown facility will be at the rate that applies when it’s taken, so this may well be better (or worse) than today’s rates.
A combination of the amount being drawn down and the time that elapses between money being taken will also serve to mitigate the overall debt owed to the lender.
This may seem to be a glaringly obvious solution. There is evidence that, since the cost-of-living crisis has started to bite, more people are using flexible drawdown lifetime mortgages. According to Key Group, in Q3 2022, £450 million of housing equity was reserved for future use, a 49% increase year on year from £301 million in Q3 20212.
Consider a Retirement Interest only mortgage (RIO)
If repayments can be comfortably supported through stable retirement income arrangements (such as a combination of a final salary pension and the state pension) whilst leaving sufficient regular money for a client’s income needs, then a retirement interest only mortgage can be considered.
A RIO mortgage provides the certainty that any outstanding loan will not increase so long as the interest repayments are made. It’s worth noting that, as part of the advice process, future affordability is stress tested, including assessing the impact of one partner dying and the sustainability of the mortgage repayments by the surviving partner.
Some interest only mortgages for retirees come with a lower (variable) interest rate but often this will be fixed for a period, like a residential mortgage i.e., 2, 5 or 10 years, rather than for life. Additionally, several such arrangements from traditional mortgage lenders may also require repayment by a specific age, which can limit their attractiveness and application to longer term retirement planning.
Lifetime Retirement Interest Only Mortgages
These come with the valuable benefit of an interest rate that is fixed for life and borrowing that will not have to be repaid until the borrower(s) die or enter long term care. Plus, should the client run into difficulty with making the mortgage repayments in the future (possibly due to the reduction in income from the death of a partner), most lenders will facilitate the conversion of the RIO mortgage to a roll-up Lifetime Mortgage. This eliminates the need to continue interest repayments and may provide greater ongoing stability for household finances.
Although these guarantees usually result in higher interest repayments, they offer important peace of mind and add to the range of options available to clients needing later life borrowing.
Partial repayments and over payments
Most lifetime mortgages and RIO mortgages will allow for penalty-free repayment of the original amount borrowed, usually up to 10% a year. Repaying capital can have a significant impact on the build-up of debt and the amount that will be available as an inheritance. Whether this makes sense clearly depends on individual ongoing, circumstances and how they may change over time.
For interest only mortgages, over-payment of the interest owed is accepted by most lenders. It is not, however, usually going to be a huge priority for most borrowers in retirement as income is likely to be needed for other things.
Ageing and Longevity
Most people go through an active phase of their retirement in their sixties and seventies but will tend to start to slow down, little by little, as they age. For the sake of argument, this tends to be more common past 75 years old.
If borrowing commences in the late sixties3, the overall impact of supporting mortgage repayments should be less as spending declines. This will be particularly reinforced if the borrowers, as in our case study below, have secure, inflation linked pensions and the cost of living is stable.
A ‘final move’ which downsizes the client(s) into smaller or specialist retirement accommodation may enable enough equity to be made available to reduce or completely pay off the RIO mortgage. The increased disposable income that is freed up due to the absence of loan repayments, will be particularly useful for funding the service and maintenance fees that retirement properties typically charge.
Case Study
Richard and Julie (both 68) fully retired three years ago with a final salary pension income from jobs in local government. When combined with their state pension, this gives them a moderate retirement income of around £35,000 a year gross.
They own their own home, now worth £350,000, which is mortgage free and have adult children aged 40 and 36.
Although Richard enjoyed secure employment in the public sector, with its associated pension benefits, his work wasn’t highly paid. When Julie decided to become a stay-at-home mother after their second child was born this further restricted household finances. After a lifetime of supporting a growing family, enjoying holidays, making mortgage repayments, and paying bills, little was saved outside of a pension for retirement.
What had been saved has now been exhausted in the first few years of retirement, leaving them with no capital to access for the ‘bigger ticket items’ things such as a bit more travel, funding home improvements and to help their children up the housing ladder.
There is more than sufficient household income to support daily living, but Richard and Julie want to consider how they might access capital to fund more of those ‘one off’ expenses.
A RIO lifetime mortgage will give them certainty that they will not end up owing more capital than they borrow, so long as they keep up with the interest payments, and that it will only be repayable on death or when they enter long term care. They like the idea that when they pass away, it will help to preserve more certainty around the inheritance they could leave for their children.
The fixed rate for life offered by a RIO lifetime mortgage gives Richard and Julie the peace of mind that there will be no nasty shocks in the future. As they get older, they intend to move and downsize to a retirement flat, using the proceeds from the sale of the family home to pay off the interest only mortgage.
If their income circumstances change, for example if Richard were to die and leave a 50% spouses’ pension to Julie, then a review of the family’s circumstances by an adviser would be required. If needed, facilitating the conversion of the interest only mortgage to a conventional roll-up lifetime mortgage may be a wise course of action to relieve the pressure on monthly income.
Finally, as they have secure retirement income with a degree of inflation proofing, they can expect to be able to comfortably afford the interest payments on the mortgage in the future.
How did this play out? (Fictitious scenario to illustrate)
RIO Mortgage Drawdown facility of £70,000 on £350,000 valuation arranged (20% LTV).
1. Initial advance (age 68) - £25,000 – money used to help children with deposits for homes, sort out the ensuite bathroom and take a three-week all-inclusive break to the Caribbean.
2. First drawdown (age 70) - £10,000 – money used to re-fit the kitchen, in conjunction with an interest free loan from the kitchen supplier, and to buy a second hand car.
3. Second drawdown (age 72) - £10,000 – money used to fix the roof on the house and to buy new carpets and an electric garage door.
4. Final drawdown (age 75) - £20,000 – money used to take a month-long break in Europe, after paying privately for Julie’s hip replacement.
(Total owed after drawdowns = £65,000 or 18.57% LTV for the original loan on a house valuation of £350,000).
5. Age 80 – the house is sold for £470,000 and the accumulated borrowing of £65,000 paid back to the lender.
6. Richard and Julie use the proceeds to buy a 2-bedroom retirement flat in the new local retirement village for £300,000. Their income can comfortably support the annual £15,000 ground rent and service charge fees in their retirement home, as not only are their outgoings lower, but their inflation linked pensions have now grown to a combined £44,498 p.a (net figure).4
7. After moving costs, they are left with £105,000 equity - £65,000 of which they are investing in premium bonds and low-risk investments. The balance is gifted to their children and grandchildren.
8. Their estate will comprise of whatever is left of the capital they invested (and any growth) plus the value of their retirement flat when it is sold after they both pass away.
Conclusion
In certain scenarios, affordable borrowing where the interest payments can be supported by retirement income, can be a valuable solution for clients who lack available capital to spend.
It brings the advantage of certainty of both monthly repayments and the debt that will be owed on death or passing into long term care. Plus, in certain circumstances, as illustrated by the case study, it can work well as part of a holistic retirement plan from early, active retirement through to later in life when things can, inevitably change and slow down.
Sources
1 Based on equity release rate of 4% in January 2021.
2 Key Market Monitor Q3 2022
3 The typical age of new lifetime mortgage customers is 68-73 years old, with 72% of customers over age 65. Source: Key Market Monitor Q3 2022.
4 Calculation based on 3% increase in pension each year from age 68 onwards.