Early Repayment Charge explained
If your client repays their lifetime mortgage early, they may be required to pay an Early Repayment Charge (ERC). Different providers calculate ERCs in different ways and it can be an area of confusion for many brokers. Below, we explore more 2 life’s ERC in more depth.
Why is there an Early Repayment Charge?
A lifetime mortgage is designed to last for a borrower’s lifetime, hence the name.
We loan money at an interest rate which is fixed for the borrower’s lifetime, with the expectation that we will not receive the money back for a period of time. That period of time is the borrower’s expected lifetime and we calculate this using mortality rates.
If the borrower decides to pay back the money early, we have to re-invest that money. If at that time interest rates are lower than at the time we originally loaned the money, the return on our investment can be significantly lower than expected. To recoup this anticipated loss, we charge an ERC.
When is an Early Repayment Charge payable?
We want to treat clients as fairly as possible, so we will only charge an ERC in the event that interest rates at the time of repaying the loan are lower than they were at the time the loan was taken out.
We base our ERC on a particular interest rate - the UK FTSE 15 Year Gilt Yield Index (we will call this the ‘long term rate’). You can check this rate any time by visiting the website www.ft.com.
When we offer a loan, we set a ‘benchmark rate’. The benchmark rate is based on the long term rate at the time the money was loaned. This rate is clearly printed in the offer document issued to applicants.
If the borrower decides to repay their loan early, we will check their benchmark rate against the long term rate. If the long term rate is lower than the benchmark rate printed in the borrower’s offer document, we will charge an ERC, as we are likely to lose money on our investment.
However, if the long term rate is the same or higher than the benchmark rate, we will not charge the borrower an ERC.
If an ERC does apply, the amount of the charge will be determined by the difference between the benchmark rate and the long term interest rate. The larger the difference, the larger the ERC, although the ERC will never be more than 25% of the initial advance. This calculation is explained in more detail below.
We believe our ERC is fair because it only applies when we are likely to make a loss on our investment, and the less loss we make, the lower the ERC will be.
Download a handy graph showing more 2 life's current benchmark rate and the long term interest rate.
When do Early Repayment Charges not apply?
An ERC will not apply if the lifetime mortgage is repaid because your client is moving home and intends to transfer this lifetime mortgage to their new property, or if they are moving into long-term care, residential care or sheltered accommodation. An ERC will also not apply if the mortgage is repaid from the sale of the home after your client’s death.
If your client moves home and wants to transfer this lifetime mortgage to the new property, they can do so if the new property meets our lending conditions at the time. If the new property is of a lower value, we may ask them to repay part of the amount outstanding on the mortgage.
How is the Early Repayment Charge calculated?
Let’s take the example of a client who is repaying their loan 10 years early. Their loan currently stands at £120,000. The long term rate at the time of repayment is 4.07%, and the benchmark rate when the loan was taken out was 4.57%.
There are three factors used in the calculation of the ERC:
Factor 1 - The number of years and months remaining until the youngest client reaches their 90th birthday.
In this example this is 10 years and 2 months = 10.2
Factor 2 - The balance on the mortgage on the day they repay (including all interest and charges)
In this example the total balance is = £120,000
Factor 3 - The difference between the long term rate on the date of requested redemption and the benchmark rate quoted in the client’s mortgage offer.
4.57% - 4.07% = 0.50%
(Please note: The ERC will be capped at 25% of the initial advance).
The ERC calculation:
Factor 1 x Factor 2 x Factor 3 = Total ERC payable OR 25% of the lump sum and the completion fee, whichever is lower, + redemption fee (currently £125)
So in this example . . .
10.2 years X £120,000 X 0.50% = £6,120 plus £125 redemption fee = Total ERC of £6,245
Assuming this is less than 25% of the initial lump sum including the completion fee then:
£6,245 would be the total ERC repayable.
For partial repayments – at the time your client decides to make a partial repayment on their lifetime mortgage, an ERC will be calculated in the same way as above, but this time will be based on the total amount that your client repays, rather than the balance of the outstanding mortgage.
If you have any questions about our Early Repayment Charges, please contact us on 08454 150 150.
