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Another round of interest rate hikes from central banks. Another month that sees mortgage rates rise, too.

Which means a bigger monthly bill for anyone not on a fixed-rate mortgage – or whose deal expires.

Oh, and inflation is rocketing. It’s already above 9% and the Bank of England now foresees 11% by October.

All of which has gifted us a cost of living crisis.

Suddenly the pound in your pocket (or your fintech app) is like a heroine in a Jane Austen novel – pursued by suitors from all sides.

We haven’t had to think about rising interest rates or inflation like this for years.

Higher and higher

Many people were shocked by energy prices soaring in 2022, for example.

Fair enough, that inflationary surge came out of the blue.

But there’s no excuse with your mortgage. We’ve been on notice that quantitative tightening was coming. Six months of interest rate and inflation speculation – as well as huge moves in the underlying bond markets, if you’ve paid attention – means we can’t say we weren’t warned.

The good news is UK mortgage rates are still low. At least compared to history.

However we have seen mortgage rates rise well off the Mariana Trench-like lows of last year.

Back then banks were practically giving away money like they used to hand out free piggy-banks.

Not anymore. According to broker L&C, the average two-year rate has trebled since October:

“…the average lowest two-year fixed-rate in June came to 2.71% and the average five-year fixed-rate rose to 2.78% … up from the historic lows of October, when an average two-year fixed rate was 0.89% and an average five-year fixed rate was 1.05%.

Mortgage Solutions, June 2022

A big jump for sure. However it is comparing today’s rates with a freakish, short-lived low.

Looking at the last 20 years to the end of 2021 better puts the recent mortgage rate rise into perspective:

Source: Statista

As you can see, today’s mortgage rate levels only takes us back to where we were in 2014. And rates have been far higher before then.

Given this headroom for still-higher rates and the pace of recent hikes, it’s not too late to stress test your mortgage. You want to find out how you’d cope if mortgage rates rise further.

For the rest of this article we’ll look at interest rate risk and your mortgage. Next week we’ll run through a checklist of other issues you might face with your borrowing.

Repayment risk: keeping up as mortgage rates rise

Most people today are on fixed-rate mortgages. In my view this is a good thing, compared to when more people were on constantly-fluctuating variable rates.

Everyone used to do a lot of opining back then about whether it was a good time to take out a fixed-rate mortgage versus some other kind of product. They’d try to predict where interest rates were going.

But there’s no good reason for the average Joe to be speculating on the direction of rates like that. We have multi-billion pound markets that struggle to get it right. You’ll probably do better only by luck.

This lack of edge isn’t the reason to go fixed-rate, though.

In fact it actually makes the case for choosing a mortgage that tracks the variable rate, perhaps with nice discount applied. That’s because in theory the market has already digested everyone’s best guess of future interest rate moves. So it should all be in today’s prices/yields.

And indeed, discount tracker mortgages that follow rates often do prove cheaper than fixed-rate mortgages over time.

No, the real reason to fix your mortgage is for certainty and budgeting.

A fixed rate is like an insurance policy. It takes the risk of higher rates off the table for as long as your fixed-rate mortgage deal lasts.

This means that if you can make your payments now, then provided your income and outgoings at least stay constant, you know you’ll be able to do so in the future.

When you have a massive liability like a mortgage tied to something as precious as your own home, that’s very reassuring.

How higher mortgage rates increase your payments

Alas, all deals come to an end. And when your current fix expires you’ll probably want a new fixed-rate deal, which is likely to be more expensive than the last one you took out.

First-time buyers obviously can’t lock-in the low rates of yesteryear, either.

So everyone will have to grapple with today’s rising rate environment.

And to belabour the obvious, these higher rates will mean higher monthly payments going out from your squeezed household budget.

Below are some examples of how monthly payments will ratchet up as mortgage rates rise. To illustrate I’ve assumed someone remortgaging with 20 years left to go:

Monthly mortgage payments at different interest rates

Balance, 20-year term	1%	2%	3%	4%	5%
£250,000 (repayment)	£1,156	£1,274	£1,400	£1,533	£1,671
£500,000 (repayment)	£2,309	£2,548	£2,801	£3,066	£3,343
£250,000 (interest-only)	£208	£417	£625	£833	£1,042
£500,000 (interest-only)	£417	£833	£1,250	£1,667	£2,083

Source: author’s maths

From the table we can see the magnitude of changes coming in people’s mortgage payments.

For example if you have a mortgage of £250,000 and you’re coming off a 2% fix, then at say 4% you’ll see your payments go up by £259 a month.

Of course you’ll have to do your own sums with a calculator to get your figures.

For my part, if I remortgaged today I’d guess my new fixed rate would be about 3.3%, judging by my lender’s current published rates.

That compares to the just-under 2% rate I’ve paid for the past few years.

A move from 2% to 3.3% doesn’t sound like much.

But with my interest-only mortgage it directly translates into monthly payments that are 65% higher.

Ouch!

The bright side of inflation

A 65% rise in monthly payments is ghastly from a sticker shock perspective, but I think I can take it. I also have a couple of years worth of payments set aside in cash as a back-up.

However if rates keep rising before I secure my next five-year term then it could start to get hairy.

(As with most fixed-rate deals, I would have to pay a small penalty in this final year of my term if I remortgage before it expires. I’d rather not!)

Higher rates stretch the case for staying invested versus repaying my debt, too.

How high would be too high? If the best five-year fix I could get was more than about double my current rate, I’d perhaps look to pay down the mortgage when my fixed term expires – or to take some other remedial action.

• Again, play with a mortgage calculator to stress test your own repayments.

The decision is not a no-brainer because inflation is running even more rampant than interest rates.

And that means today’s very high inflation is eroding the real terms value of our mortgages at quite a clip.

In fact if you’re paying 3% interest on a mortgage when inflation is running at 9%, then you’re kind of getting a real return of 6% on your debt!

In practice there’s more to think about. If your salary isn’t outpacing inflation or house prices go into reverse, you may not feel so lucky. And the ‘real return’ from a negative mortgage rate applies at a real terms net worth level. It’s obviously not actively reducing your nominal mortgage balance.

Also – crucially – you must be able to make your mortgage payments to benefit.

Repossession during a huge economic downturn is to be avoided at all costs!

So can you afford the higher payments?

Of course, simply seeing how your monthly payments are going to jump as mortgage rates rise doesn’t do much but give you heartburn.

You now need to take this figure and assess how it affects your overall household budget.

One way to do this is to calculate your interest cover figure. This is similar to how companies indicate their borrowing level to investors.

To do this you simply divide your monthly after-tax income by your monthly mortgage payments.

For instance, if you bring home £3,300 post-tax and your mortgage is set to cost £1,000 a month, you have an interest cover of 3.3x. That shows you could pay your mortgage more than three times over from your income, ignoring the other demands on your money.

However as that innocuous ‘ignoring’ suggests, I’m not sure how useful this figure will be for most.

You can perhaps compare your new coverage level to your current one to get a sense of how much more stretched you’ll be with higher payments.

But really, for individuals who occasionally take out a two-to-five-year fixed rate mortgage, it’s better to think in absolute terms rather than comparative ratios.

I’d simply plug your predicted higher monthly mortgage payments into your monthly budget if you have one – or into your best guess if you don’t.

What is left over after paying the mortgage and all your other bills? How much are you eating into your disposable income? (Will you still have any disposable income?)

The answer to these questions could warn you it’s time to tighten your belt.

If you want to get fancy, you could even model out the life of the mortgage term and inflate up your other spending to try to forecast a few years ahead.

If you do this, don’t forget that – hopefully – your take home pay should be increasing, too.

Longer-term interest rate risk: could mortgage rates rise to 10%?

The outlook for rates (and inflation, and the economy) is very uncertain.

The market seems to think rates and inflation will more or less settle down within the next couple of years. And that ultimately the wailing “awooga!” sirens will turn out to have been a temporary notice to take cover. As opposed to warning of a long-lasting stagflationary apocalypse.

However we’ve never before come off 5,000-year lows for interest rates. Let alone after a global pandemic. Never mind while a war rages in Europe.

So could we see interest rates head higher than expected? Mortgage rates of 6%? Or 8%?

It’s possible. But I do find it hard to envisage.

If mortgage rates rise much above 6% or so, many people could struggle. We might then see a wave of defaults, forced sales, a house price crash, and a vicious downward spiral.

At the same time the government would also face huge rises in the cost of repaying the national debt. Perhaps taxes would rise.

It all sounds deflationary – and likely to cause the Bank of England to cut rates.

That’s not to say it couldn’t happen. And I’m definitely not making a moral case for bailing out homeowners.

I just think it’s likelier that the Bank of England – and the UK Treasury – would lean towards accepting higher inflation versus triggering economic meltdown.

Indeed given the UK is carrying more than £2 trillion in national debt, many politicians might see chronic debt-eroding inflation as something of a happy outcome.

We are (probably) gonna make it

There are cataclysmic views out there as to how this all ends, but I’d keep some balance.

For instance since 2014, the Bank of England has mandated new borrower’s should face a stress test to see if they can still afford their mortgages if Bank Rate rises by 3% over a five-year period.

That’s one reason I believe we’ll escape a total meltdown as long as mortgage rates stay below 6%.

But who knows? All sorts of costs are rocketing and piling on the pressure, and there’s not much you or I can do about the big picture anyway.

Our challenge is navigate these choppy waters while preserving our future financial security.

How we save and invest is a big part of that, as is staying in the game as mortgage rate rise. So get stress-testing – and start to take some budgetary evasive action if you have to.

Next time I’ll go into more detail about my own stress test. Subscribe to ensure you get it.

An accumulation fund has a very simple job and that is to automatically reinvest dividends for you.

Instead of paying out your dividends (or interest) as cash, your income is put to work buying more of the fund’s underlying assets.

The counterpart to an accumulation fund is an income fund. An income fund sends dividends to your broker account for you to spend, save, or reinvest as you wish.

Income funds give you freedom to choose how to use your dividends. In contrast accumulation funds directly harness the power of compound interest to build your wealth.

Because they do that automatically, they make life simpler when growth is your priority.

What is an accumulation fund?

An accumulation fund is a variant of an open-ended investment fund. Standard open-ended investment fund types include Open-Ended Investment Companies (OEICs), Unit Trusts, and Exchange-Traded Funds (ETFs). 

An open-ended fund such as a global index tracker may be made available in different versions that are known as share classes. 

A single fund may come as an accumulation share class or as an income share class. Think of them as two flavours of the same thing – or perhaps the accumulation class as like the convertible version of your favourite car. 

Both share classes represent your ownership of the same portfolio of underlying assets. But the classes confer different rights upon you.

In the case of the accumulation class of a fund, your dividends will be retained and reinvested for you in that fund. 

An accumulating fund (or ETF) is just another name for an accumulation fund. The same goes for the terms acc fund or capitalising ETF. 

They all do exactly the same job. That is to reinvest your dividends back into the fund. 

How do accumulation funds work?

Accumulation funds work by purchasing more shares in the companies they hold with the dividends earned from the underlying investment portfolio. 

This grows the value of your fund’s acc units (or shares), like a stalagmite reaching for the ceiling of a cave. 

Bond accumulation funds work the same way. As your interest payments roll in they buy more of the fund’s underlying portfolio of bonds.  

Your dividends do not buy you more units1 in an accumulation fund. That’s different to what you’d expect if you manually reinvested your income.

Instead, the reinvested dividends increase the worth of the underlying portfolio. This pumps up the price of every accumulation unit you own. 

The effect on the value of your holdings is exactly the same as if you bought more shares with your dividends, however. 

Our piece on income vs accumulation funds includes a chart that proves the point. The compounding happens — but in the price of the unit.

The upshot is that you’ll pay more for each unit of an accumulating fund than for one of its income fund counterpart. 

But that doesn’t make the inc fund a more attractive bargain than the acc version. 

Unit economics

Imagine the Monevator FTSE Human Folly Index Acc fund where:

• The accumulation units are priced at £2
  
• The income units are priced at £1
  

For every £2 that you have to invest, you can spend £2 to bag two £1 income units, or alternatively your £2 could buy you one accumulation unit.

Let’s now suppose the fund goes up 10%.

• The accumulation units are now worth £2.20
  
• The income units are now worth £1.10
  

Your cash return would be identical at 20p, whether you’d bought two income units or just one accumulation unit.

The only performance difference is that accumulation units will without doubt be compounding your dividends.

In the long-term, the value of a compounding accumulation fund will leave its non-compounding income twin in the dust. 

But remember, the income unit owners are getting all those dividends to spend straightaway when they’re paid out. There’s no free lunch for anybody here!

When do accumulation funds reinvest dividends?

Accruing dividends are reflected in the price of an accumulation fund as they trickle in from the underlying investments. 

Fund managers will reinvest at the most opportune moment while balancing investor cash inflows, outflows, and transaction costs. 

However, accumulation funds still have an ex-dividend date. This determines whether you’re entitled to receive the dividends collected up to that point. 

The day before the ex-dividend date:

• Fund units bought on this day are eligible for the declared dividend.
  
• Units sold on this date are not eligible.
  

The ex-dividend date:

• Previously held fund units sold on this day are still entitled to the declared dividend.
  
• Units bought on this day are not.
  

This all matters if you hold accumulation funds outside of your ISA or SIPP. That’s because tax is due on dividends, interest, and capital gains earned from acc funds, just as it is on income funds. 

But calculating the tax you owe differs slightly as you must subtract your dividends from an accumulation fund’s capital gain. That way you’ll avoid being taxed twice on the same amount. 

Our post on UK tax on reinvested dividends walks you through the calculation. 

Thankfully you should receive a tax voucher from your broker detailing dividends earned on each of your accumulation funds, if you own them in taxable accounts. 

Keep that paperwork safe. It’s paracetamol for self-assessment pain. And complain if you’re not receiving the voucher.

(Your first one may only arrive after the end of the first tax year that you’ve owned your accumulating fund.)

Dividend details

Your dividend entitlement doesn’t make any difference to the amount you buy or sell an accumulation fund for.

Accrued dividends are always baked into the price.

If you’re ineligible for the dividend when you bought – that’s okay. You haven’t inadvertently gamed the system. Your dodgy dividends are cancelled out because you effectively paid for them in the higher buy price. 

And you don’t lose out on dividends rightfully earned when you sell. That’s because they’ve already swollen the sale price you receive.

Rest assured the system smooths out the complications, even though it’s not exactly intuitive. 

Do accumulation funds pay dividends?

Yes, accumulation funds pay dividends. But they reinvest them straight back into your investment to boost its performance.

The dividends aren’t deposited into your broker account as cash as they are with income funds. (The way to realise acc fund dividends would be to sell units of your fund up to the value of the dividend.)

But how can you enjoy the thrill of watching your dividends payout like a fruit machine win when you can’t see them rack up in your account?  

Well, you can track how much tax-sheltered accumulation funds have been fattened by dividends using the technique below…

How to find dividend distributions for accumulating funds

To find the dividend distributions of your accumulation fund:

• Go to Trustnet and search for your fund using the drop down menus on the home page.

• Most index funds will be in the Unit Trusts & OEICs section of the Fund Universe menu.
  

• There’s an ETF section in the same menu.
  

• Obscure foreign-domiciled funds and pension funds can be found in the Offshore Funds and Pension Funds drop-downs respectively.
  

• Click on the dividend tab from the fund overview.
  

• Make sure you click on the right fund. Trustnet tends to bundle lots of similarly named fund variants in the same place. This piece on comparing funds explains how to distinguish them.
  

• Multiply the dividend amount by the number of units you held the day before the ex-dividend date. That tells you how much you’ve earned in pounds and pence. 

• Enjoy closet kicks from seeing the money flowing from Global Capitalism plc to You plc.

• Possibly plot the gains on some kind of spreadsheet. (How much do you want to stretch out the joy?)

Trustnet doesn’t always come up trumps. Here’s an alternative method:

• Go to Investegate’s advanced search page.

• Put your fund manager’s name (e.g. iShares) in the Company Name field.

• Set the All Categories field to Dividends.

• Change the Time Span field to something more generous like six months.

• Click the Search box if nothing happens automatically.

• A list of dividend payment announcements should come up.

• Click on the Dividend Payments link in the right-hand column.

• The dividend announcement should pop up. Read it and you’ll hopefully find your fund and its dividend result somewhere within.

Alternatively you can check your fund’s annual report, or email the fund provider.

Happy hunting!

Take it steady,

The Accumulator

1. The same rules apply if your fund holdings are described as ‘shares’ not units. I’ll just use the term unit from now on to save time. [↩]

What caught my eye this week.

A lot of people daydream about what they’d buy if they won the lottery. This chance to fantasize is probably the most tangible benefit of a lottery ticket.

Not me, though.

I appreciate this is almost-too on-brand – but I daydream about how I’d invest it.

I’ve told friends and family they wouldn’t even know if I won the lottery. I’d simply scale up my investing, and maybe slack off the little paid work I still do.

Eventually they’d see me spending more – hopefully on experiences we can share, as much as mere ‘stuff’. But nobody would know it wasn’t just from my portfolio finally paying off.

Nope, as a closet/Bohemian investor for decades, a run-of-the-mill lottery jackpot (low seven-figures say) would first just make for some chunky extra entries in my return-tracking spreadsheet.

In it to win it

Perhaps you think this is desperately sad?

Fair enough. But do consider the surprisingly terrible track record of lottery wins ruining lives.

Against that danger, I believe my strategy of turbo-charging my existing way of life with an extra million or two – rather than racing to build a hot tub on my shed or to buy a pet tiger – has psychological merits as well as financial ones.

Indeed, you should be careful what you do if you receive a windfall of any size.

That’s because a significant lump sum has the potential to compound meaningfully for the rest of your life – with all that possibility for more freedom and independence – while at the same time a big windfall can easily implode your current cozy way of life like a fiery meteor landing in your living room. Upsetting all your arrangements and generally freaking you out!

Anyone who gets a big lump sum out of the blue has had one of life’s luckiest financial breaks.

But it can cause – and may come with – mental issues that need to be worked through, from guilt at sudden wealth, to sadness about where the money came from (the death of a parent or spouse, for instance).

It could be you

For these reasons, Advisor Perspectives this week also urged doing nothing fast if you’re fortunate enough to get a windfall:

Whatever the situation, I always tell clients who receive a windfall to do nothing for an entire week. Absolutely nothing. They must give themselves time for the reality of their new circumstances to settle in.

That’s because windfalls are usually the result of something that has happened. And that, in turn, can trigger our emotions.

Stepping away from the fray and doing nothing is underrated in many areas of investing. This is another one.

Now you might think that as a regular Monevator reader you’d be a rational Vulcan if a life-changing lump of dough was suddenly bunged into your financial oven.

And perhaps you would be, long-term.

But in the short-term we’re emotional creatures. Which can make you temporarily crazy. And once you go the wrong way, things can escalate.

So let’s have some fun…what would you do if you won a million pounds?

Buy a boat? Abandon a life of frugality and speed past the Jones’s? Start betting on risky growth stocks to aim for ten million? Spread the lot across a dozen (FSCS-protected!) bank accounts to ensure you were set for life, at least if you ignore inflation?

Share your fantasies in the comments below. And have a great weekend.

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