Mind over mortgage
Do you know your debt capacity?
When faced with interest rate uncertainty, the question often is, ‘should I pay down my mortgage?’ At Y TREE we instead seek to answer, ‘what is your personal and financial capacity for debt?’
The cultural psychology of debt and homeownership
In the UK, our homes are our castles. They represent financial and emotional security.
Many of us grew up with the idea that owning bricks and mortar means you’ve made it. Homeownership is just one of the many inevitable steps in the journey to adulthood – your parents probably said so; politicians definitely did.
At the same time, property in the UK has been a profitable and mostly reliable investment. This, coupled with a long period of historically low interest rates, has meant that many have been keen to access significant mortgage debt for their spot on the land registry.
But recent events have prompted even those with the most solid financial foundations to take a closer look at the debt they hold.
As of 1 November 2023, according to Moneyfacts.co.uk, the average standard variable rate mortgage reached 8.19% in the UK1.
This marks a swift departure from the low interest rates of the previous two decades. A return to those rates, at least in the short-term, feels unlikely.
So, with 1.6m fixed-rate mortgages due to expire in 2024 according to the Resolution Foundation, this new environment has prompted some key questions: should I pay off, or pay down, my mortgage? Should I leverage up my balance sheet?
Interest rates in historical context
First, let’s look at interest rates in the context of history. For many, the mortgage hikes of the past year feel unprecedented. Of course, they are not. Recency bias is a cognitive prejudice that means we tend to emphasise recent events over historical ones.
Low interest rates are actually abnormal when you put them into historical context. The chart below shows the ebb and flow of base interest rates in the UK over the last few decades. As rates rise and money gets more expensive, so too do mortgage rates as lenders seek to pass on the cost to their customers.
1 Frost, G. (2023, November 21). Will UK mortgage rates keep going down in 2023? – Times Money Mentor. The Times. Retrieved November 24, 2023, from https://www.thetimes.co.uk/money-mentor/article/mortgage-rates-uk-news-will-they-go-down/
Bank of England Interest Rate History
When mortgage rates were around 1.5%, it felt like a no-brainer to take on as much cheap debt as the banks would lend. Any surplus cash could be invested in the markets, where returns would almost always exceed 1.5% after tax.
However, with interest rates at a 15 year high and debt now considerably more expensive, it is difficult to generate investment returns that beat the cost of the debt, at least via public markets.
What is the right level of debt for you?
When faced with interest rate uncertainty, the question is often, ‘should I pay down my mortgage?’ At Y TREE, we seek to answer, ‘what is your personal and financial capacity for debt?’
It’s easy to assume that your bank will only approve you for a mortgage you can afford. The problem is, your bank’s methodology for approving your mortgage will largely depend on your profile as a borrower today – your current household income, credit rating and asset base. Your ability to afford your mortgage over 25 or 30 years will depend on many other factors such as the shape of your balance sheet over time, your goals and objectives, and evolving market conditions.
If you take on too much debt and an unexpected market event happens, your retirement or later life care could be in jeopardy. So, how much mortgage debt can actually you afford? Our proprietary asset liability modelling engine enables us to take a more analytical, data-driven approach.
What is your long-term capacity for mortgage debt?
£5,000,000
Assumed maximum mortgage debt bank will lend
£3,200,000
Affordable mortgage debt based on Y TREE modelling
What is asset liability modelling?
Y TREE brings the processes of the world’s leading institutions to individuals. When we talk about institutions, we mean big endowments (like Harvard and Yale), pension funds and some of the largest family offices.
Leveraging knowledge from the fields of computer science, statistics and applied mathematics, we have developed an asset liability modelling (ALM) engine to solve your most complex financial problems. Using technology, we have made it accessible and, more importantly, understandable for everyone.
Institutional investors are always balancing assets with liabilities. They manage the gap between the two and constantly assess whether they have the assets to safely cover their short-, medium- and long-term liabilities. This is a complex science but, to simplify, these institutions want to hold more assets than they need to meet their objectives in case something goes wrong in the future.
Of course, we can’t predict what’s going to happen over the next 30 years, but we can plan for a broad range of possible scenarios. By leveraging statistics and big data, our engine models how interest rates, windfalls, tax, inflation, pay rises, economic downturns and all the rest can impact your assets and, crucially, your debts. We use technology to give you this financial life intelligence in an intuitive way.
Are you betting your later life care on the property market?
Y TREE can help determine a sustainable level of mortgage debt for you in this new interest rate environment. This means finding that crucial balance between achieving enough growth in your investment portfolio to fund all of your life aspirations and protecting you from running out of money too soon in the event of a market downturn.
We achieve this by taking into consideration your personal attitude towards debt, your financial situation and goals, and stressing the results for the unexpected. This is a holistic approach that results in a debt level right for you, not the bank.
The following graph shows the impact that having too much mortgage debt could have on your ability to retire comfortably or fund later life care in this new higher interest rate environment.
In this example, if a market crash similar to 2008 were to occur today, a family who has a £7m property and a £5m mortgage with a fixed 10 year rate of 5.04% would see their investment portfolio exhausted by the time they reach age 91.
In contrast, if they paid down their mortgage debt to £3.2m, based on analysis by Y TREE, their balance sheet could endure a market crash and last until age 100 whilst still funding all of their life aspirations.
Are you betting your later life care on the property market?
Footnote: Assumes investor has a £4.9M investment portfolio, a £7M property, a £1.3M annual income to retirement and additional expenses related to 3 children.Y TREE models the impact of refinancing existing mortgage of £5M with either a £5M (orange line) or £3.2M (blue line) interest-only mortgage in year 1 at a 10 year fixed rate of 5.04% (HSBC), then dropping to 4.70% in line with implied 25 year mortgage rates. Assumes the investor downsizes the property in year 24 (age 70), releasing £5.5M in property value, which is then invested back into the investment portfolio after paying off mortgage debt and any taxes. A 2008-like market stress is also simulated in year 2, lasting 3 years. 2023/2024 UK tax rates. Investment portfolio is 70/30 equity/bond.
The Y TREE difference
We really believe that money is only meaningful when it’s being spent on what matters most to you, your family and your community. While our technology can produce an acceptable debt level based on data and mathematics, only you can answer the question, ‘what makes you most comfortable?’ Your personal circumstances and attitude towards debt are unique to you.
At Y TREE, we combine asset-liability modelling with bespoke advice when it comes to debt and liquidity risk. Your dedicated team of expert advisers will work with you to agree a path that works for you and your family, armed with all the intelligence of the world’s leading institutional investors.
We are bringing money back to life.