The evidence is mounting that 2022 has seen a regime change for interest rates. Quantitative tightening (QT) is the new quantitative easing (QE). Everyone should stress-test their mortgage and other debts to see how they’d handle higher rates.
There are two main things to consider:
The cost of servicing debt (a function of interest rates, plus spurious add-on charges)
The ability to get debt if you need it (how willing are banks to lend)
Both will likely get worse for most borrowers as money tightens.
Of course if the screw is really turned we will see second-order effects.
For instance markedly higher rates could cause the housing market to slow or unemployment to rise. That could hit your finances directly (you lose your job) or indirectly (a stock market or house price crash).
Keep going with such extrapolation, however, and you begin to sound like the economic nerd cousin of Stranger Things’ Dustin Henderson.
“High rates will crush growth even as de-globalization fuels hyper-inflation, spinning us into a stagflationary death loop that sees Jeremy Corbyn and Boris Johnson re-elected as leaders of extra-radicalized parties that wage running battles in a crumbling Trafalgar Square.”
I’d draw the line several steps before reaching – let alone acting upon – such conclusions.
It’s not that things can’t change radically. (Nor that you shouldn’t have a Plan B, just in case).
Things can definitely change a lot:
In the 1970s it was hard to get an expensive mortgage to buy a cheap flat in a depopulating London.
In the 2010s it was easy to get a cheap mortgage to buy an expensive flat in a booming London.
However it’s very difficult to make even short-range economic forecasts accurately.
Massive shifts? Trying to see everything proceeding as you have foreseen – ten years away – is a fool’s errand.
Rather, like judging the weather, it’s usually better to assume more of the same – summer, say, as opposed to winter, or vice-versa – and to focus on the disposition of any clouds on the horizon.
Higher interest rates
What makes doing so tricky this time – and what has roiled markets in 2022 – is that we probably are in a new season.
That’s the regime change bit, right? But I don’t yet see that we’ve fast-forwarded from a balmy June into the depths of a winter solstice.
So far quantitative tightening has mainly been felt in interest rates.
Take the five-year gilt yield as a rough-and-ready driver of rates for fixed-rate mortgages.
The yield on this gilt is back to 2014 levels:
Correspondingly, five-year fixed-rate mortgages have become more expensive.
Tack on 1-1.5% for the bank’s trouble of lending to you rather than Her Majesty’s government and the typical five-year fix is now above 3.5%. (Albeit you can do better if you shop around.)
That’s not too terrible, but some pundits see things getting far worse.
One analyst recently told What Mortgage:
“Given the speed of rate rises this year, as the mortgage market catches up it is not unrealistic to see the average five-year fixed rate at 5% next year.”
This is not an outlandish prediction, though I’d be surprised. While today’s rates are in unfamiliar territory for anyone who has only been saving and borrowing for the past few years, they’re still historically low.
We only have to expand out the view above to 15 years to see the five-year gilt yield above 5% in 2008:
You’ll remember 2008 was the watershed for a little thing called the Great Financial Crisis. Its aftermath saw yields plunge and the start of the quantitative easing that we’re now exiting, via quantitative tightening.
So 5% yields – and maybe 6-7% five-year fixes – are possible if we truly have left behind the great sloshing post-crisis money splurge.
Note though that the market does not currently see 5% as remotely likely, judging by signals such as the yield curve:
Source: Bank of England
Sure, there’s no anticipation of a return to recent ultra-low yields. But there’s no fear of 5% interest rates, either.
Indeed as of the Monetary Policy Committee’s last meeting in June, market pricing for the Bank of England’s Bank Rate was 2.9% by the end of 2022, peaking at 3.3% next year.
Is that a spike in your inflation graph or…?
The elephant in the room is, of course, inflation. High inflation that persists for longer than anticipated could see more interest rate pain inflicted than is currently priced in.
Hardly anybody saw inflation or rates being where they are now, this time last year. So the market is hardly infallible.
And trying not to see high inflation these days is like trying to tell your brain not to think of a pink elephant:
Source: Office for National Statistics
Just this week inflation hit a 40-year high of 9.4% in the UK. It has gone bananas, to use the technical term.
Market predictions for another big rate hike from the BOE hardened on the latest inflation report. However for those of us not trading day-to-day moves in the bond market, higher Bank Rates were already effectively priced in.
The key questions now – which I do not propose addressing in this post – are (1) whether inflation is still a relatively short-term spike, and (2) whether more rate hikes will do much to bring it down anyway.
There’s lots of opinion to digest out there. Call it right and you can be more confident about where mortgage rates will go.
Personally I believe inflation is more likely to be significantly lower in a year or two than higher. I still see most of the inflation as an aftershock of the stop-start pandemic, albeit with additional factors such as fiscal stimulus and war.
More importantly, the market agrees. And for what it’s worth the Bank of England still believes we’ll be back at around 2% inflation in a couple of years:
The rate of inflation is forecast to keep rising this year. But we expect it to slow down next year, and be close to 2% in around two years.
That’s both because the main causes of the current high rate of inflation are not likely to last, and because we have raised interest rates several times over the past few months.
True, I’d take that prediction with a fistful of salt. Both on the grounds of the Bank of England’s wonky forecasting record and because I do not believe that it will do ‘whatever it takes’ to bring inflation back to 2% if it has to.
Given the already surging cost of government borrowing and the likelihood of a deep recession if rates go a lot higher, I suspect the Bank would countenance elevated inflation at, say, 3-4% for a time as more palatable.
Admittedly 3-4% is not in its mandate. But it could probably obfuscate.
Then there’s also the ongoing friction burn from Brexit – slowing growth and adding to inflation at the margin.
Doing my own stress tests versus higher interest rates
So that’s a snapshot of the scenic features in today’s economic landscape. I concede it’s a cloudy picture. And possibly I have my finger over the lens.
But what does it mean for our mortgages?
I went into detail about stress-testing your mortgage a few weeks ago. We especially focused on rates. Please go back and read it (and the comment thread) if you’ve not done so already.
This rest of this post is the promised follow-up as to how my thinking is evolving around my own controversial mortgage.
My situation is unusual – interest-only mortgage, got it weirdly, self-employed, and (sort-of) financially independent – but hopefully my musings will be food for thought.
Or just plain voyeurism! I mean, it could be a bit of a thriller for viewers.
The fixed-rate term on my mortgage expires in February. That’s unfortunate, given Bank Rate could be peaking shortly thereafter.
With a bit of luck however five-year yields and beyond will already be dropping by then. Albeit perhaps because recession is looking more likely, which may in turn make banks more reluctant to lend cheaply.
Clearly there were easier times to refinance an interest-only mortgage. Such as most of the past four years.
My mortgage: naughty but nice
I got my interest-only mortgage for a variety reasons.
Most obviously, I wanted my own home!
But I also wanted to keep my tax shelters intact, rather than withdraw money from my ISAs to buy a flat mortgage-free. If I’d done that then much of my painstakingly accumulated ISA tax-shield would be lost forever.
I also judged cheap mortgage debt would help ease the pain of any unexpectedly high inflation that emerged from the near-zero rate era.
Inflation erodes the value of debt, in real terms1. All things equal this makes the debt less of a burden over time.
Look at that inflation rate in the chart above. With inflation where it is, I’m currently earning roughly 7% in real terms on my mortgage. That’s incredibly attractive, all things being equal.
But of course all things are rarely equal.
For starters, to benefit from the negative yield I must be able to make my mortgage payments. Running a mortgage that I could otherwise pay off from my investments means assuming a risk that effectively levers up my portfolio.
That is, I am borrowing to invest via my mortgage. And the cost to do so rises with higher interest rates.
This brings up the second aspect. What did I do instead with the money that I could have used to pay off my mortgage?
I have had it invested, mostly in equities.
For the first four years this was a boon. But the wheels have come off this past six months.
I’m still up on where I would have been in cash terms – without adjusting for the extra risk I took by investing and taking on debt – thanks to my gains over the first three and a bit years.
However share prices have been falling for months in 2022 even as higher interest rates make funding their ownership more expensive.
And that means investing via the mortgage doesn’t look like the no-brainer it was as recently as November.
Higher interest rates: fine, within limits
To cap it all, my income from work is severely down over the past 18 months or so.
That was by choice – I sort of drifted into living the financially independent lifestyle. As the market soared in 2021 I stopped renewing my freelance gigs. I didn’t formally decide to quit work.
Why this happened and whether it should have is for another post. The point is I’m tending to think as if I’m living off a sustainable withdrawal rate (SWR) on my assets. Even though in reality I still do have some earnings.
Of course, there’s one huge comfort when running a big portfolio alongside a big mortgage. If you really must you can sell whatever you need from the former to cover the latter.
To my mind this makes what I’m doing pretty safe. I’d certainly prefer it to paying my mortgage with a salary and no savings.
Ideally though, I want the portfolio to continue to grow to meet future demands, FIRE-style. Hence I think of my mortgage payments as coming out of my notional SWR rather than drawing down capital.
At my current rate of 1.99%, the payments are easily covered by earnings, let alone the portfolio.
At a rate of 4%, which I judge a good bet for February – up from the 3.5%-ish my bank is touting today – the monthly mortgage payments would still be less than a third of my vague SWR.
A mortgage rate of 6% does get uncomfortable. Note there’s no immediate danger at all. I could continue for decades at this rate, and the chances are good that withdrawals would be covered by portfolio growth. In that case I’d still grow richer. But ‘probably’ starts to loom larger in the long-run picture.
Obviously I have other living costs besides the mortgage. Even a blogger has got to eat!
But I am presuming I’d revert to my old graduate student lifestyle if I have to – if there’s a long bear market and no income rebound – which is actually plenty swanky for me.
Would investing rather than repayment still be worth it?
The always-contentious issue of having a big interest-only mortgage while investing is tilted by higher interest rates, too.
Regular readers will remember I shared a spreadsheet for calculating the benefits (or otherwise) of investing instead of paying off a mortgage.
We’ve established in the comments over the years that this mostly comes down to personal attitudes.
However there’s no denying the allure of the interest-only mortgage fades as rates rise.
At a 2% rate, running a £500,000 interest-only mortgage compared to a standard repayment mortgage could deliver an additional £542,000 in net worth after 25 years, assuming 7% returns.
With a 6% mortgage rate, that (theoretical, not guaranteed) extra gain falls to just £84,000.
This are simplistic sums that ignore inflation, the jagged path of real-world investment returns, and the significantly higher risks of running a mortgage.
On the other hand, 7% returns are much lower than what I’ve achieved over the past ten years (albeit in a bull market!)
The point is that the savaging inflicted by higher interest rates on ballpark returns is clear.
My gut feeling is that at rates much above 4% I’d probably switch to repayment.
Money’s too tight to mention remortgaging
My unusual circumstances – my bank’s CEO initiated my home loan process, remember – make my remortgaging situation potentially tricky.
However I recently spoke to my bank. Its staff confirmed in a worst case I would automatically go on to the standard variable rate.
The agent also claimed I’d be able to switch to a new fixed rate a couple of months before my current term expires – without having to go through that unusual application procedure again.
But I’m still wary. I’m outside the normal Venn diagrams. And the specific employees who sorted my loan have since moved on.
Moreover this agent was not an expert, just a front-line trooper. (The call I made was recorded. I might need that in a push!)
Refinancing is a formality for most people. Even more so now mortgage affordability stress tests have been weakened. But my odd circumstances make it a bigger concern for me than higher interest rates.
The good news is the investment portfolio that backs the repayment of my loan is (for now) still well up since I got the mortgage in 2018. Even after this year’s declines.
Nevertheless in early 2022 I moved much more than I otherwise would into lower-volatility assets:
I’m trying to increase the odds I will look like a good credit risk to the bank. In my situation that means keeping my net worth up for the remortgaging window in February.
I want to reduce volatility on a big chunk of my portfolio just in case I want to pay down my loan. Perhaps because rates surge or the bank decides it now has a problem with me.
It may even turn out that moving on to the standard variable rate for a while won’t be my worst option come February.
Plan B if the computer says “no chance”
In general I’d always favour fixing, for the certainty of payments.
But my remortgaging window seems likely to open shortly before an inflection point for rates. It could be worth giving it six months (presuming this doesn’t impair my ability to actually fix again, due to my odd situation.)
What’s more, most fixed-rate mortgages come with restrictions on over-payments. There are none on my bank’s standard variable rate, however. That would enable me to reduce debt – and risk – quickly if I felt wobbly.
If push comes to shove – if I don’t want to make big repayments or I can’t secure a halfway decent fixed-rate residential mortgage – I’ll possibly even switch to a buy-to-let mortgage, turn my flat into an investment property, and spend a few years living abroad.
This might seem dramatic, even for a Plan B.
But remember I’m a single guy and I work from home.
Truthfully I should probably be taking advantage of the whole Digital Nomad opportunity anyway!
Five years a mortgage slave
Finally some psychological and emotional reflections.
One of the more unusual reasons why I got my mortgage was to see how I managed as an active investor carrying a lot of debt.
How would I feel with this potentially deadly obligation on my balance sheet? Could I cope? Would it change how I invested? Would it be worth it?
Well I’ve learned I don’t love it and it’s probably not good for my stock picking.
I was concluding this even before the recent market falls.
For instance I’m pretty sure I wouldn’t have sold Tesla (and various other dumb things I did in 2018) if I wasn’t discombobulated by my then-new mortgage.
And while in theory even a modest return that’s leveraged by an interest-only mortgage can deliver great returns with lower stock market risk, in practice I’m still drawn to riskier growth shares.
This reality also made it easier to shift a large proportion of my assets out of equities entirely and into what I dub my new ‘low volatility’ portfolio in early 2022.
As mentioned it has tamped down the overall volatility in my net worth, as well as making me confident I can make big or even total repayments in February 2023 if I need to.
I’m also happier focusing my now right-sized equity portfolio towards riskier equities with this buffer at my back.
Given this year’s declines, I lucked out with the timing. But if I still feel I need to keep a large slug of safer assets even after I have successfully remortgaged for another five years, say, then it could be a drag on my returns.
It might be a sign I am having emotional trouble scaling my risk profile via the mortgage as I age, as a couple of astute readers have already suggested.
Mathematically, too, a lower expected return portfolio might compare poorly versus simply paying off my debt. Especially given higher interest rates.
Running a mortgage at a rate of less than 2% and investing is a different proposition compared to higher interest rates at 4-6%, as we’ve seen above.
My original plan was to run my big mortgage for the full 25 years to take advantage of the return spread and inflation.
But I’m starting to think I’ll probably pay it off sooner than I’d imagined.
I’m in no rush to decide on this, especially now shares are cheaper. Falling share prices increase their expected returns, even absent any stock picking alpha I might rediscover.
However if and when markets recover I may well redirect future spare cash flows towards the mortgage.
I’m only human after all, it seems.
Time will tell. Stick around to see how the story ends!
That is, inflation-adjusted.
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Everything is worse when rates rise.
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