This article on using an offset mortgage comes courtesy of Planalyst from Team Monevator. Check back every Monday for more fresh perspectives on personal finance and investing from the Team.

Paying for a home versus investing is a hot topic for the FIRE1 masses.

However I was late to this party.

I had already plunged in with the societal expectation that everyone starting a family should buy a ‘proper’ house. So that’s what I’d done.

And with that came a mortgage.

Laying the foundations

When I bought my first home in 2008, I hadn’t heard of the FIRE movement. I’d not even considered I might not keep working until State Pension age.

But I still wanted my mortgage debt paid off as soon as humanly possible.

Like most people who go down the home ownership route, my mortgage is the biggest liability I intend to incur in my lifetime.

(I’m aware that the Student Loan is a hefty debt for many graduates these days – including me. But I have less control or choice over its enforced repayment from my salary.)

My ideal was that once the mortgage was repaid I could focus on saving what had previously been mortgage payments into retirement savings.

A few years ago me and Mr Planalyst had created a whopping great budget spreadsheet. We now used this to plan how to pay off the mortgage faster.

Everyone should planalyse as often as possible in my (Excel work)book!

Discovering the offset mortgage

We chose a classic fixed interest-rate mortgage product, rather than a variable rate mortgage.

The fixed rate ensured efficient monthly budgeting. It also protected us against interest rates increasing again. They haven’t actually done so since the financial crash – but, as with most things, we only know that now with hindsight.

Anyway, when it came to the end of our fixed term five years ago, I looked around on comparison websites, intending to remortgage to another fixed interest-rate deal.

It was at this point the offset mortgage option piqued my interest.

And I’m glad I did my research, because it has proved its worth.

Offset mortgage, you say?

I’m going to assume you’re familiar with the concept of a mortgage, be it a fixed or variable interest-rate. However you may not be as well-acquainted with the offset options out there.

An offset mortgage enables you to ‘offset’ the balance of your outstanding mortgage with a cash balance held in a linked savings account.

Your monthly interest calculation is then based on the overall debt across these two accounts, rather than just your mortgage borrowings. The monthly payment to your mortgage company will therefore be lower than if you just had a normal mortgage product. That’s so long as you hold cash in the linked account, of course.

There are also a few options at the policy anniversary when the interest and mortgage capital balance are recalculated. You can reduce the term length or reduce the monthly payment or it’s possible to keep the same monthly amount and term as with a usual mortgage, in order to pay your debt off faster. This was what we did.

Sadly, you don’t earn any interest on the linked cash account (so it suffers from inflation risk).

However you’ll pay less loan interest instead. This saving should make up for what you could otherwise have earned on your cash.

Offset mortgage mathematics

The maths in favour of an offset mortgage works because your mortgage will usually have a higher interest rate than any cash savings account you’ll see in the wild.

The rates touted by offset mortgages are as low as 1.39% right now. That’s cheap, but it’s still higher than you’ll earn on a cash savings account.

Getting a return on your cash by reducing your debt repayments rather than earning interest also means taxpayers can store higher cash amounts without the risk of HMRC wanting its piece. This makes an offset mortgage very tax-efficient.

Even taking into account the small bit of interest I’d earn if the cash were held in a deposit account elsewhere, I’m paying less interest owed on the mortgage versus capital repayments each month. This means I’m eating away at the outstanding capital debt much faster than with my previous conventional mortgages.

It’s all clearly visible on my mortgage calculation spreadsheet, with its nicely downward sloping lines:

Note that the slope gets steeper the more that is added to the offset savings. That is very satisfying.

Offset with benefits

Committing surplus cash to the mortgage was all well and good in the early days of our indebtedness. Our goal of financial independence only materialised years later, and with it the need to accumulate wealth.

Nowadays I have a family, too. So I had to balance those responsibilities and my new FIRE ambitions with my desire to repay the mortgage quickly.

I therefore mentally earmarked my offset mortgage’s linked cash account as an all-important accessible emergency buffer.

The linked cash account can also offer quick access to cash for less devastating events. Maybe you’re a stockpicking type who has been waiting for the right moment to invest in a company you’ve followed for years? A dip in a firm’s fortunes can be your opportunity when you’ve cash to hand via an offset mortgage.

In the meantime and whatever it’s earmarked for, your cash is working to reduce your debts rather than earning diddly squat in a deposit account.

Paying off your debt

Emergencies and opportunities aside, the cash in your offset account can be committed – in part or in full – to the mortgage capital at any time.

Alternatively you could just wait until the end of your existing fixed-rate term and then reassess.

On my mortgage, there is no early repayment charge on up to 99.99% of the outstanding balance. That has made a big difference. We’ve been able to pay the capital down more quickly and ended up paying less in interest over the life of the mortgage.

Of course, different lenders will have different rules on the amount that can be thrown into actually repaying the outstanding debt. You can typically repay 10% without any early repayment penalties. The financially-savvy Monevator audience should certainly read the small print before signing.

If committing all your savings is too much to bear thinking about without a cash safety net squirreled away elsewhere, you could hold the same balance in the linked cash account as you owe on the mortgage.

Like this, you would pay no interest on the debt, but you’d maintain your emergency cash. Monthly payments would be 100% capital repayment. It would almost be like having a mortgage with no mortgage.

Of course, this method means that ultimately you would start to build up a surplus amount in your savings account – earning zero interest.

But you could periodically remove the excess cash to invest elsewhere.

Planalyst’s journey

I didn’t have a big mortgage to begin with. For one thing I had a chunky deposit. I was also lucky with the housing slump in the recession in 2008.

As a first-time buyer I could afford to be choosy and I chose a probate property with a ‘motivated’ beneficiary. That pushed the agreed price down even further.

Doing the sums, I was shocked the monthly mortgage repayments on my new three-bedroom semi-detached were about half the rent I was paying on a tiny two-bedroom flat overlooking Basingstoke train station.

And I wouldn’t be funding a buy-to-letter’s house in Cyprus. Instead I would be my own landlord.

So I would say I’m an advocate for buying your home if you can. We moved again for work and better schools five years ago. The mortgage repayments are still lower than the equivalent rent on my now four-bedroom semi.

I’m also happy to say that – with a few more months of additional savings into the linked cash account – I’m on track to pay off my mortgage this September. That in turn means I’ll avoid paying the bank – well, building society in my case – another 12 years of interest payments, too.

Once the mortgage is paid off, its associated monthly outgoings will instead be redirected into ISAs and the investments discussed on Monevator by The Investor et al. (Fingers crossed for another long-term bull market.)

Paying off my offset mortgage will be my first major milestone on the track to financial independence and the ability to retire early in my mid-forties.

Hopefully I will feel the anticipated exhilaration of being mortgage-free a bit more than The Accumulator did!

Over time you’ll be able to see all Planalyst’s articles in her dedicated archive.

1. Financial Independence Retire Early [↩]

What caught my eye this week.

Finally my co-blogger The Accumulator has won the acclaim he so richly deserves.

No, not a plaudit for achieving the most active puns in a passive post.

Not the Leo Tolstoy Award for Services to Word Counts Beyond The Call of Anything Reasonable But Rather Really Excessive Haven’t You Even Heard of Twitter 2021 Edition.

Not even a retrospective of his black and white cartoons at the V&A.

But rather, a notification from The Motley Fool’s All-Star Money to tell us The Accumulator had won their article of the week spot with his Fighting The FIRE Demons post.

And the prize?

This artist’s impression of The Accumulator in bobblehead form:

Now, given how The Accumulator has cultivated an air of anonymous mystery around these parts, you might wonder why we’re so ready to share this homunculus with you all?

And the answer is you’re more likely to see The Accumulator doubling down on a triple-levered ETF than rocking a tie.

Meanwhile that wodge of cash would be out of his hands and invested into a long-term tracker fund before you could say, “I’ve worked out the terminal value of my round compounded in VRWL for 25 years and on reflection I’m sure I can hear my bus pulling up outside.”

And while TA is just as devilishly handsome as Bobblehead TA, our man is also older, more careworn, and about as likely to grin as Boris Johnson announcing a third wave.

In short, anonymity is preserved!

Nevertheless, it’s a wonderful treat from the All-Star Money team – thank you guys – and the least TA deserves after a decade of peerless posts for Monevator.

Just so long as he doesn’t expect a pay rise.

Have a great weekend everyone!

[continue reading…]

Signs of higher inflation abound. Beating inflation to preserve spending power is therefore high in many investors’ minds.

Bank of England chief economist Andy Haldane chimed in just this week, reports Reuters:

“If wages and prices begin a game of leapfrog, we will get the sort of wage-price spiral familiar from the 1970s and 1980s,” Haldane said, adding that inflation would not be on the same scale as in those decades.

In an interview with LBC radio earlier on Wednesday, Haldane said inflation pressure in Britain was looking “pretty punchy”.

9 June 2021, Reuters

Of course, predictions of higher inflation rival England’s football team for hype versus reality.

Surging inflation and English football glory have both been notably absent for many decades.

Inflation’s coming home

Indeed, one way to preserve the real value of your pound would have been to bet against England at every major tournament in my lifetime.

You’d probably have multiplied your initial stake nicely by betting that way – and reinvesting the proceeds each time.1

Betting against England might be a way of beating inflation.

However nobody sensible would say betting for or against England was a way of hedging against inflation.

While I haven’t earned a PhD crunching the numbers, England’s footballing performance surely has no correlation with inflation.

A sports team – and hence your bet – will win or lose irrespective of the inflation rate, in other words.

Whereas a hedge against inflation would be expected to protect against a decline in the spending power of your money due to rising prices.

Multiplying money via a wager – and so getting more spending power, beating inflation – doesn’t mean you actually hedged against inflation.

Beating inflation with a Banksy

So far so obvious – albeit dispiriting for England fans.

Yet the same confusion between beating inflation and hedging against inflation appears often in the investment world.

Right now asset managers are marketing their products as inflation hedges.

Here’s an advert I saw on Facebook under the banner: “Want a hedge against inflation? Invest in art today.”

Who wouldn’t want a 16,347% return over 13 years? Sign me up!

Actually, not so fast.

On these numbers, this (unnamed) piece of art would have been a fabulous investment.

But the advert tells us nothing about whether art is good for hedging against inflation, as opposed to beating inflation.

True, the 16,347% return equates to almost 50% a year on a simple annualized basis. Unless you’re getting clobbered hyperinflation, a 50% return a year will surely do a good job of beating inflation.

It would also turn anyone with a few paintings in their attic into multi-millionaires.

But I’m highly skeptical that anyone should expect a typical piece of art to go up in value near-50% a year over the next 13 years.

Annual returns around the 7-8% range from art are more typical what I’ve seen touted.

Yet even if your art choice did so well, I’d congratulate you on your luck or a great eye – but not necessarily on your choice of an inflation hedge.

At least not just because its price went up a lot.

To view art as an inflation hedge, we’d need a thesis as to why art should hedge against inflation (easy – real assets tend to go up over time, with inflation) and data showing correlation (I’ve never seen that for art).

Equities have a record of beating inflation

What about shares? Many people – me included – tend to think of equities as protecting against inflation.

We have our reasons. Companies can lift prices in response to inflationary pressure. They often own real assets such as land and property. Over time profits and dividends can rise – in contrast to bonds with fixed coupons. All of this means share prices can rise in the face of higher inflation.

However the authors of the Credit Suisse Equity Yearbook refute this notion.

The renowned academics divided equity and bond returns into buckets representing different inflationary regimes – from marked deflation through stable prices to very high inflation – as follows:

Their work shows the return from bonds varies inversely with inflation. At times of deflation (left-hand side) bonds do very well. They get smashed by high inflation (right-hand side).

Equities do much better than bonds most of the time – the exception being times of extreme deflation.

But real returns from equities are negative with very high inflation, although they still beat bonds.

We can’t really call equities an inflation hedge then. Not when their real return falls with high inflation!

The professors note:

These results suggest that the correlation between real equity returns and inflation is negative.

i.e. equities have been a poor hedge against inflation.

There is extensive literature which backs this up. Fama and Schwert (1977), Fama (1981), and Boudoukh and Richardson (1993) are the three classic papers.

Credit Suisse Equity Yearbook, 2021

If this fact is so accepted in academic circles, why do we think of owning equities in the face of rising inflation?

It’s because the returns from equities have a strong record of beating inflation over the long-term.

Shares do not hedge against inflation. But the magnitude of their out-performance versus other assets means over many decades and cycles they’ve typically delivered the best returns, easily beating inflation.

What assets really hedge against inflation?

Generally you want to own real assets – ‘stuff’ – when inflation takes off, if you want to hedge against inflation.

After all, inflation in part expresses how the price of stuff is changing.2

The following from Bank of America (via Trustnet) shows such correlations:

Most things are positively correlated to inflation over the long-term.

Even cash! (That’s because interest rates tend to rise as inflation rises.)

The big exception is long-term government bonds. These are negatively correlated.

If inflation heads a lot higher then you’d look at returns from long-term bonds through your fingers. From behind the sofa.

Note the image shows correlations, not past or future returns.

The price of platinum is strongly positively correlated to inflation. That doesn’t mean platinum will necessarily be a brilliant investment.

Picking your poison in 2021

The best hedge against inflation are products designed for that purpose.

Index-linked government bonds, perhaps a basket of inflation-linked corporate bonds, or NS&I index-linked certificates.

However index-linked bonds are very expensive today. They are vulnerable to interest rate rises.

Corporate bonds introduce credit risk.

As for NS&I certificates, they aren’t even available to new investors. They also pay a pathetically low real return to those who already own them.

You’ll be hedged against inflation with NS&I index-linked certificates for sure. But you’re guaranteed to only just beat it…

Beyond that – and set against everything I’ve written above – I believe most of us should concentrate more on beating inflation than hedging against it. For a private investor with real world spending concerns, the long-term outcome is more important than the short-term correlations.

For most of us that means a healthy allocation to assets like equities and property – and crossing our fingers that we don’t face 20 years of stagflation. (You might want to own some gold in case of that).

Given how strongly correlated bonds are to inflation – they will surely do badly when inflation is running hot – you could argue holding fewer in a portfolio is also an effective way to dial down inflation risk.

However the more you reduce your government bonds, the more exposed you are to stock market falls – and also to deflation.

Beating inflation over the long-term

Finally, what do you know about inflation that the market doesn’t? It’s been constant media chatter for months now.

Someone somewhere is always warning of higher inflation.

I first saw that Bank of America forecasting imminent inflation – complete with an earlier version of its correlation image I included above – in the Financial Times in 2016.

And before that, at the start of QE I worried – like most people who didn’t work at the US Federal Reserve – about the inflationary consequences of monetary expansion.

Well it’s been 12 years and we’re still waiting!

Remember, if you’re working your income is likely to rise with inflation. Also if you own a house with a mortgage, over the medium-term inflation will probably push up prices while whittling down the real value of your debt.

Passive investors are probably best mostly sticking to a diversified portfolio, with a mix of assets aimed at beating inflation over the long-term, while also guarding against other scenarios.

If you want to gamble, punt on your national football team!

1. I’m assuming you’d earn a return on your stake between tournaments. And I haven’t done the maths! But given England hasn’t won anything since the 1960s I’m confident. [↩]
2. The other part is changes in the price of services. [↩]