It’s a Tracker!

Who dare not give, and ev’n refuse to lend
To their poor kindred, or a wanting friend.

I remortgaged in October. It’s a tracker. Factoring in the expected BoE interest rate rises over the coming two years, it’s very obvious that I’ve gone for the most expensive of the four options I looked at. And no, I’m not addled.

Since the beginning of October 2018, when I signed on the dotted line, the number and likelihood of BoE rate hikes have been revised down 😀 , albeit I suspect not enough to materially alter the numbers in my mortgage comparison spreadsheet. Because: Brexit uncertainty is grinding the economy to a halt.

Here’s the rest of my thinking:

  1. Assuming the Parliament does not pass Mrs May’s deal, and assuming a two-year time horizon:
    • If there’s a No Deal Brexit, I’m betting on a recession. The BoE will dare not raise the rates. Tracker = good call.
    • Even if it does dare, it won’t be by much. The pound will crash in the short term, so the global stock markets will be expensive for a British investor to buy into, and the best use for my money will be to overpay the mortgage. That’s when unlimited overpayments on my tracker will come in handy. Tracker = good call.
    • If there’s a second referendum and No Brexit, the rates will probably rise, albeit the BoE is likely to proceed with caution. But the pound will rally, which will make me very happy, as the global markets will be cheap again for any Earned O’the Mighty Pound. Hence any pain from my mortgage will be mitigated by a share-buying opportunity, plus the general happiness of their not being a Brexit. Tracker = bad call, but I don’t care.
    • If there’s a delay in Article 50, while the Tories sort out their shit, the most likely outcome is that the pound rallies a bit, but rates don’t rise until there’s clarity. Tracker = good call.
    • If there’s a Corbyn government and a delay in Article 50, my pension allowance and ISA allowance are likely to be slashed and taxes increased. The pound will probably stay about the same or fall a little, and there’s likely to be a further slowdown in the economy, if not a recession. Because: more uncertainty and the expectation of the same shit charade we’ve all been watching for two years now. So: (1) With less ISA and Pension allowance and higher taxes I’d have even more incentive to overpay the mortgage, and (2) I recon the BoE would probably put any rate increases on hold. Tracker = good call.
  2. Assuming the Parliament passes Mrs May’s deal (unlikely):
    • The pound will rally (How much? Nobody knows), which will put a lid on inflation and somewhat mitigate the need for the BoE to raise interest rates. Also, the current Brexit-induced stockpiles of inventory will have to be used up/ sold down, so the GDP numbers won’t be splendid (again, the BoE won’t be in a rush to raise interest rates immediately).
    • Eventually the rates will increase, and, assuming I make no overpayments, I’ll lose out on a tracker vs the best-buy two-year fix I could have had. However, I’ll be renting out my digs shortly, so some of the interest will be tax deductible, and that will take some bite out of any (eventual) movements in interest rates. Tracker = not great, but not a disaster, either.

It appears to me that there’s more on the upside than on the downside here. What do you think?

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Mortgage Overpayments

Capital Ring
‘T is here, in different paths, the way divides; The right to Pluto’s golden palace guides; The left to that unhappy region tends, Which to the depth of Tartarus descends.

The blogosphere is full of musings on whether one shobuld invest or pay off the mortgage first, and then invest. Both arguments have merit[1].

To invest, or to repay the mortgage, that is the question.
– Hamlet

Cash is interchangeable, so when I buy stocks and shares while keeping a mortgage I’m investing borrowed funds. I am not entirely comfortable with leveraged investing, and I most of what follows should be read with that in mind.

I’m also a higher rate tax payer. To me a personal pension has significant tax advantages. Because: 25% tax free lump sum that can be handed over to the bank at a perky young age of 58 along with a note asking them to please chisel their name off the land register and return the title deeds to my pile of bricks, thanks.

Raise a glass to freedom

Financial success is objectively quantifiable. To an aspiring FIRE’ee, a decision of investing vs repaying the mortgage should be a simple function of tax efficiency and expected risk-adjusted return. Alas, we all carry the baggage of our parents’ views on money, not to mention our own bad financial decisions. It tends to get in the way of rational thought.

Let the past die. Kill it, if you have to.

In 2012 I made a mistake of buying more bricks than I needed by taking on a larger mortgage than I was comfortable with. Because: I had no fecking idea what I was comfortable with, and buying as much house as the bank would allow was all the rage back then.

Now I’m getting I am sick and tired of being tethered to that infernal loan and all that comes with it, such as three-hour remortgage calls where I must discuss my spending habits with a clueless 20-something mortgage adviser, who tells me that £6k in interest and fees over the fixed rate period is cheaper than £5k in fees and interest over the same fixed rate period. I’m tired of having to worry about keeping my job for the fear of losing my home. I hate owing money.

There’s no way I’d pull the FIRE plug without repaying my mortgage first.

Do I hate paying tax more than I hate having a mortgage?

The answer is, mostly, yes.

So this makes a pension – with all its uncertainties and restrictions – my vehicle of choice.

Tax laws may change

Since 2006 there have been more than a dozen changes to lifetime and annual allowance, mostly aimed at reducing the amount I can save into my pension. In addition, both the annual and lifetime allowance have been reduced by inflation. They will begin indexing the lifetime allowance from April this year, but that may also change. Because: Corbyn.

Even without Corbyn, if our fair country’s finances become truly dire, the government may seek to increase tax revenue by abolishing the 25% tax free lump sum. If they were to grandfather the pensions already in drawdown, this could be accomplished with a loss of a relatively small number of votes. We humans are surprisingly amenable to being robbed, provided there is no immediate impact.

How about an ISA then?

When it comes to clairvoyance, I see just as far into the future as anyone else. Having said that, I think that HM Treasury would find ISAs more difficult to tamper with than pensions, and probably less profitable.

ISA savings pots are generally lower, additional tax revenues would be less predictable, and the population of disgruntled voters a lot larger. The annual ISA allowance could be reduced with limited grumbling from the public (the majority of the electorate don’t have £20k p.a. to chuck into stocks and shares), but that’s about it.

Mortgage overpayments vs ISA

My current plan involves retiring at 45 or thereabouts, so I’ll need non-pension savings to tie me over until I’m 58. This makes an ISA not only attractive but necessary.

The opportunity cost of overpaying my mortgage is the tax free investment return I could have had by investing the money in an ISA instead. Historically shares have generated about 7% p.a., which is much more than my current mortgage interest rate. Is it right to compare a long term stock market return with my current mortgage interest rate at a time when stock valuations are at a historic high and mortgage rates are at a historic low? Who knows. ¯\_(ツ)_/¯

ISA contributions come from post-tax income, ditto mortgage overpayments. Investment return inside the ISA wrapper is tax free, but so is any mortgage interest saved by overpaying.

The only sticking point is that ISA allowance can’t be carried over into future tax years. Even on fixed rate mortgage deals overpayments tend to be more flexible than that, and most trackers allow unlimited overpayments. If I fail to take full advantage of the ISA allowance for a few years because I’m busy overpaying my mortgage, then later, having extinguished the mortgage and finding myself with more investable cash than ISA allowance, I’d have to use taxable accounts. I know I’d regret that. Because: I hate paying tax more than I hate having a mortgage.

Mortgage overpayments vs taxable investment accounts

Keeping a mortgage while investing outside the tax wrapper is borrowing to invest without any mitigating factors. That would take larger cojones than I possess, so I’m afraid I’ll have to pass, thanks:

  1. A mismatched risk profile on the asset vs liability side. Investment grade bonds aren’t paying enough to cover my mortgage interest, even before taking tax into account. Hence my hypothetical taxable investment would have to be shares, which are exposed to a number of risks not mitigated by the short position on the mortgage side, such as business, forex (either directly or indirectly via the issuer’s geographical distribution of revenue), regulatory… Monevator wrote about it recently.
  2. Tax. For a higher rate tax payer, expected investment return has to be rather high to make the game worth the candle. FTSE 100 dividend yield is currently 3.9%, so, ignoring dividend allowance[2], my mortgage interest rate over the remaining life of the loan has to be less than 2.6% to break even. Any capital gains will help, but they will be subject to a 20% capital gains tax.
  3. Timing. Given the current CAPE, and the historical relationship between equity valuations and interest rates, the time when I’m likely to be most inclined to decrease my mortgage principle – when the rates go up – is likely to be the time when I’m most likely to be in the red on the invested capital side.

Mortgage overpayments are part of my Fixed Income allocation

Housing costs – in whichever form – are inevitable. As Ermine of Somerset once put it, a hairless mammal in Northern Europe will always need a home. The rule of thumb is that housing should cost up to a third of net income. This would imply that home-owning financially independent early retirees should aim have up to a third of their net worth tied up in home equity.

In addition to the above, I don’t think that a person’s primary residence is an investment in the housing market. I consider my home to be an annuity that will pay my notional rent for as long as I live.

In its essence, home equity is an inflation-linked fixed income instrument, and therefore, assuming a classic 60/40 portfolio, the total value of fixed income securities plus home equity should be less than half of my net worth. It is not. By this measure, I’m very overweight on fixed income vs stocks. Given current PE and CAPE of equity markets, this may or may not be a bad thing, but the point stands.

So what’s the plan then, Sherlock?

It’s a tough one.

Come April 2018, I’ll have no more carry-forward pension allowance. For the first time in what feels like an age there will be more than a few spare pennies to allocate between the mortgage and the ISA.

The case for repaying the mortgage as soon as may be is a solid one. From purely emotional point of view I’d like nothing better than to be rid of it. The whiny little loss avoider inside me would love to be rid of it even if it meant delaying early retirement by a year or two. Regardless of what happens in the markets in the next 10 years, I’d find it difficult to regret owning a mortgage free home.

BUT, financial independence is a numbers game, and numbers tell a slightly different story. I am underweight on equities in the context of my total net worth. Moreover, by trying to not waste a single penny of my pension allowance, I’ve been lately remiss in the article of emergency money. I can use my ISA allowance to rectify for that; a cash ISA can be moved to stocks and shares at a later date.

So, for the coming 12 to 18 months my plan will have to be:

  1. Use up all pension allowance;
  2. Use up all ISA allowance, and put most of it in cash to top up the emergency fund;
  3. Overpay mortgage with whatever is left.

Notes:

  1. Except when people say that mortgage overpayments, by increasing home equity, also increase exposure to the housing market. And so we shouldn’t put all our eggs in one basket, etc. That is nonsense. I took 100% of my exposure to the housing market when I exchanged contracts. The fact that there’s a mortgage is irrelevant: it has no impact on any future (hypothetical) gains or losses I’ll make on my place, and the loan will have to be repaid regardless of what happens to it.
  2. Why can I ignore the dividend allowance? Because: it reduces my pension allowance under the pension taper rules.