What is COMPOUND INTEREST ?

Compound Interest is the addition of Interest to the the original loan value plus any accrued interest, in other words, INTEREST ON INTEREST.

The Rule of 72

The Rule of 72 is an easy way of calculating how long it would take for a debt subject to a fixed rate of interest to double when the interest is compounded.

Divide 72 by the interest rate to give the number of years in which the debt will double.

This example is for as property valued at £250,000, a loan of £100,000 at a fixed interest rate of 4%

so the calculation is               

 72 divided by 4 (%)  =  18 (years)

therefore a £100,000 loan @ 4% interest would double in 18 years to become £200,000 

I have used 4% as an example above. Interest rates are extremely low at the moment, generally around 3%, so the sum would be  72 divided by 3  =  24 (Years).

Remember the days of higher interest rates ??

Here is the sum using a rate of 7.2%          72 divided by 7.2  = 10 (Years)

There were, of course, some mortgages at that type of high rate which wiped out the equity in many cases, hence we see people screaming " Don't touch Equity Release" !! 

Be sure to have your Equity Release Adviser explain the effects of compound interest on the equity of your home, if you are considering taking cash out of your property.

So, there you have the downside of Compound interest, however there are two sides to every story.

 This interest also works to our benefit as well, where property can increase in value using Compound Interest also, sometimes even in excess of the rate of inflation and of course we know that property can also reduce in value.

Compound Interest and Equity

I have produced below a table showing the effects on equity using the above example with a mortgage loan @ 4% and using a growth rate in value of the property at 2% per year.

It can be seen that the equity figure remains fairly stable at around £150,000 for the duration of the term.                    

Of course, the Mortgage interest rate has a major bearing on the equity figure. You will remember when we had mortgage rates of over 7%. Equity Releases taken out at that rate of Compound interest certainly ate up the equity which is why many people shout and scream about equity release being dangerous and wiping out the equity.

Here is the same table as above BUT using the rate of 6% interest !!

So now you see why people are shouting about Equity Release and saying "Don't Do It". Fortunately those days of high interest rates have passed and we now are seeing rates below 3% fixed for the duration of the Lifetime Mortgage.

In fact, here is the same table using a 3% fixed Lifetime Mortgage

So, in this scenario, we see an increase in equity. The reason being that we receive the 2% Capital Growth on the whole of the property value whereas the 3% Mortgage Interest, although compounded, is only on the sum borrowed.

I hope that this has dispelled the myth of "You will have no equity left to give to your children"

WATCH MY "WHAT IS COMPOUND INTEREST ?" VIDEO

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Pat Cunningham  CeMAP,  CeRER