It’s no secret mortgage rates have crashed. But unless you’ve been following the housing market with – oh, let’s say the morbid curiousity of a renter who was waiting for a London house price crash and got another boom instead – you may not realise just how low rates have gone.

First Direct has a five-year mortgage with a fixed rate of 2.69%. Even with an arrangement fee of £1,999 and the need for a 35% deposit, that is remarkably cheap – and while it’s the best I could find, there are other lengthy fixes around.

In fact, what I find most remarkable about these low rates is just how little remarking is actually being done.

Why are these puny rates not raved about like soaring Dotcom stocks or National Lottery winnings in the 1990s? They’re more lucrative for most people.

Are the UK’s homeowning gentry just so smug and comfy in their castles that they don’t realize interest rates are at a level not seen since Dr Johnson and Boswell were out flat hunting?1 And that rates were slashed mainly to keep them – and their creditors – in clover?

Or do some secretly appreciate that they’ve been handed a once-in-several-generations bailout, so they’re keeping schtum in case they spark a middle-class riot?

Whatever, I think if you’re solvent, earning, and you haven’t got a mortgage – and that includes me – then it’s looking like you need one.

Mortgages are not like other debts

A mortgage is the only good debt. The term mortgage comes from the French for “death contract”, but for decades mortgages have enabled people to enhance their lives by buying their own home without saving a six-figure sum beforehand. Over the long-term, that house can be expected to increase in value.

Some old wolf will come along and tell us that mortgages are terrible if there’s a big recession and you lose your job and interest rates rise, and you can’t keep up the repayments. Wise and true.

Fact is though, nearly everyone reading this article will at some point have a mortgage. Better to get them when they’re cheap, and around here we’re smart people who only take on mortgages we can easily afford.

Don’t think that because mortgages are okay, you can feel fine about a five-figure credit card bill. No way. All other debts are toxic and poisonous – with the arguable exception of student loans – and must be purged before you take another holiday, eat at another restaurant, or buy another Superdry windcheater.

I was challenged the other day by a commentator who thought my view that debt is a form of protection against high inflation was reckless. Fair enough, he or she was not a regular, and may not know I have a Berserker attitude towards all debt other than mortgages.

But anyone who thinks a mortgage is bad news when inflation is running high is wrong.

An affordable mortgage secured on a real asset – a house – is an excellent thing to have at times of high inflation.

Times, as it happens, like now.

How inflation is paying off your cheap mortgage

Mark it in your diaries: Wednesday 13 February was the day Mervyn King, the Governor of the Bank of England, said he would pay off your mortgage for you.

Of course, Mr King is not going to dole out cash for you to wheelbarrow down to your nearest branch of Lloyds.

But King did admit inflation was likely to stay above target for at least a couple of years, and that he was going to do diddlysquat about it.

So same difference.

Look at this chart, which shows the Bank of England’s famous fan projection of the likely rate of inflation:

The dark red line is the Bank’s central projection for  inflation.

You’ll notice inflation is headed to 3%. You’ll remember the cheapest fix is only charging you 2.69%. That’s one heck of a deal.

Sure, you’ll have to make debt repayments every month. But for the next couple of years, it’s likely that inflation will be eroding a First Direct mortgage as fast as the bank can bill you for it.

Result! At least for anyone with a cheap mortgage, and for a nation sliding into financial repression to pay off its debts.

If you’re a prudent and debt-less saver like me, it’s time to wake up and smell the coffee. The authorities have other priorities. We can moan about it, or we can get in the game and protect ourselves against inflation.

Re-mortgage and save a fortune in interest

If you’re already a homeowner and you are not on a super-cheap mortgage, it’s got to be worth seeing how much you could save on mortgage repayments.

When remortgaging, remember to account for arrangement fees and any early repayment penalties (there’s no stamp duty, since you’re not buying a new house) to make sure it really is cheaper overall.

Should you go for a discount, tracker, or fixed rate mortgage?

That’s an article in itself, but I’d be tempted to lock-in a cheap five-year deal here. Rates have fallen again because of the Funding for Lending scheme that’s designed to get banks pumping out cheap loans. It won’t be around forever.

I know the best rates require decent deposits, and that while I limp on in high house price hell here in London, prices have been falling elsewhere. So it’s possible the equity in your home has shrunk, making it harder to get the top deals.

But are there other sources of funding you could throw into the pot to increase your equity and so bring down the rate you can apply for?

Given the paltry interest on cash, it’s likely to be worth using savings to increase your deposit if it gets you a lower mortgage rate. Do the maths and see.

Indeed, given where rates are, I think it’s almost a “sell your possessions” moment for remortgages, like shares were in March 2009.

Do you need two cars? Do you need that conservatory or loft extension, or can it wait a year? Can granny advance you your inheritance?

£10,000 might be the difference between a super-cheap 2.69% rate and a still cheap but not quite so bargain bucket 3.39% rate.

• On a 20-year repayment schedule, a £200,000 remortgage at 3.79% will cost you £85,586.60 in interest.

• A £200,000 remortgage at 3.39% still racks up an interest bill of £75,675.15.

• After chucking an extra £10,000 into the pot to get a cheaper rate, £190,000 at 2.69% costs you just £55,878.73 in interest.

Wealth warning: Mortgage rates will surely be higher some day. These numbers are just to illustrate the savings between two relatively low rates. Make sure you can cope if rates double, at least.

Of course the time value of money means £10,000 pumped into your mortgage now is worth more than £10,000 saved in the years to come.

But what else will you do with it? Low rates mean cheap mortgages, but they also mean cash saving rates – even inside an ISA – are pitiful.

If I were a super-cautious saver, I’d not muck about with cash on deposit outside of an ISA (beyond my emergency fund) if by redeploying it to build up my deposit I could slash my mortgage rate.

Remortgage and invest?

Of course, I’m not a super-cautious saver. I’m a childless 30-something who is happy to have lots of my money in shares.

So I lust over these mortgage rates for a different reason.

I’ve written before about the dangers of borrowing to invest. However I said the one exception may be if you can:

• Borrow via a mortgage (it’s cheap, long-term, and not marked-to-market)

• Invest to earn an after-tax return above your mortgage rate

• Invest the money inside a tax shelter – an ISA or a SIPP – in order to do so

• Be certain you can meet the repayments from your salary. (i.e. Do not rely on your investment to repay the debt).

Hedge funds would kill for long-term funding at 2.69%, such as we can get from the cheapest fixed rate mortgage deals today. Over a couple of decades shares should deliver far higher returns than that.

So that’s a big reason why I’d love a mortgage – alongside its usefulness as a hedge against inflation. (I’m not wild about having to use one to buy an over-priced house, but I’m coming around to throwing in the towel on that).

This is not for everyone. Borrowing to invest, even via a mortgage, greatly increases the risks. Also, these low mortgage rates won’t last forever, so you shouldn’t overstretch.

I’m thinking here of a 40-year old withdrawing say 5-10% of equity for prudent long-term investment, not a 60-year old pulling out 20% to punt on penny shares.

Incidentally, I have no idea how closely a bank will look at what you plan to do with any money you raise on remortgaging. I suspect it varies.

Banks were happy enough in the boom times to allow the withdraw of mountains of cash for cars, kitchen extensions, and summer holidays – in the last quarter of 2006 mortgage equity withdrawal accounted for over 7% of disposable income!

But no doubt in their new chastened form some won’t go for using their cheap funding for sensible long-term investment.

(Here is the benefit of an offset mortgage, where you can shift cash at will).

Remortgaging to fund a pension

I’ve written a lot more about borrowing via a mortgage to invest, so I won’t repeat myself further. I’d just add that if you’re a higher-rate taxpayer and you’re not currently funding a pension, it could be even more worth you doing the sums.

Let’s say you want to put £30,000 into your SIPP, to invest in a cheap FTSE 100 tracker fund for the long-term. After tax relief, that’d cost you only £18,000 taxed income. (I’m assuming for the sake of argument you pay sufficient tax to qualify for full higher rate tax relief).

If you’re getting 40% tax relief and your investment gains are tax-sheltered, you’re borrowing at 2.69%, inflation is running near 3%, and the FTSE 100 is yielding well over 3%, then a lot of things are working in your direction.

You don’t even have to invest in shares – at these low hurdle rates and inside a tax shelter other assets could work.

One cunning strategy might be to buy some of the floating rate bonds I mentioned the other week. When I did they were paying 4%, so well in profit versus a 2.69% mortgage rate, provided you’re invested within a tax wrapper. If and when interest rates rise – so increasing your mortgage rate – the coupon they pay will rise too, ensuring the trade stays profitable.

Like this you could hedge out interest rate risk, and eventually see a nice capital gain. (Remember you’ll face credit risk, so keep diversified overall).

Remortgage your way

I’ll repeat myself because some people always argue against things I don’t actually write. (Hey, it keeps me on my toes!)

I am not saying this last idea of remortgaging to invest is something we should all do. I’m definitely not suggesting anybody should withdraw £100,000 of arguably over-valued housing equity to punt on tinpot oil explorers.

I’m thinking more like a limited withdrawal to fund an ISA or a SIPP for a year, while equities still look fair value. Many people have too much wealth tied up in their house and not enough in shares. They could be more diversified.

Super cheap mortgage rates are an unprecedented opportunity and inflation is a growing risk, and so more financially creative readers might want to think about how to best respond.

As always though, please remember I’m just a humble scribbler, not a financial adviser, so do your own research and make your own decisions.

1. That was the 1700s, TOWIE fans. [↩]

It’s a question of cost control and is the main issue fund-toting investors must resolve now that sweet-smelling RDR is here to turn the financial advice industry whiter-than-white.

The question comes down to this:

• Are you better off with a portfolio full of investments that siphon off mucky ol’ commission to your broker from the fund fees?

• Or should you go for clean class funds that are superficially cheaper (because they don’t pay commission) but instead force brokers to cake on extra fees to wash their face?

The short answer…

The likely answer is that investors with small portfolios are better off with brokers that still provide old-style commission funded services. If you pick your platform wisely then you can avoid flat-rate charges such as platform fees and dealing costs that take a disproportionate chunk out of a smaller portfolio.

In contrast, investors incubating a large clutch of assets can more easily absorb flat-rate costs. But they should steer clear of percentage fees that swell along with the portfolio.

So how small is small and how large is large?

Let’s find out.

The long answer…

Step 1 is to find out the total Ongoing Charge Figure (OCF) of your portfolio.

Just multiply the OCF of each fund by its percentage allocation in your portfolio. Then add up your results to clock your portfolio’s total OCF.

For example:

Fund	Allocation	OCF	Weighted OCF
Total Market tracker	70%	0.5%	0.7 x 0.5 = 0.35%
Property tracker	20%	0.4%	0.2 x 0.4 = 0.08%
Gilts tracker	10%	0.2%	0.1 x 0.2 = 0.02%
Total Portfolio OCF			0.45%

If you get commission rebates from your existing broker, don’t forget to subtract those from your fund OCFs.

Now match up the total OCF of your dirty portfolio against the cost of its clean class alternative.

For example, the total OCF of Monevator’s Slow and Steady passive portfolio is 0.37% if using dirty funds.

The clean class version has a total OCF of 0.24%.1

Multiply your total OCF by the size of your portfolio to find out how much you’re paying in charges.

For example:

• £10,000 x 0.0037 = £37 (annual cost of dirty fund portfolio).

• £10,000 x 0.0024 = £24 (annual cost of clean fund portfolio).

Thirteen pounds. That’s all the OCF cost savings on a portfolio of this size amount to for being squeaky clean. If your prospective broker is going to charge you more than that in additional fees, then go down the dirty route.

And there isn’t a post-RDR broker out there who is going to charge you less than £13. So much for RDR helping small investors.

Obviously, if the dirty portfolio is subject to other costs then you should count those too, although that won’t be a concern if you choose a fund supermarket like Cavendish Online.

The breakeven point

So what does it take for the clean class to win? How large does your portfolio need to be?

Continuing the example above…

The difference in OCF cost between a dirty and clean portfolio is 0.13% (0.37% – 0.24%).

We’re looking for the point at which that 0.13% difference is worth more to us than the annual costs we’d incur with a broker selling clean funds.

The broker BestInvest charges £60 a year in custody fees to own clean funds. There are no dealing fees for funds to worry about, which keeps things nice and simple.

The calculation is:

£60 / 0.0013 (or 0.13%) = £46,154

That’s the breakeven point at which the cost of a dirty fund portfolio costing 0.37% a year equals the cost of a clean portfolio costing 0.24% plus £60 in broker charges.

i.e.

£46,154 x 0.37% = £170.77 total cost

£46,154 x 0.24% = £110.77 + £60 = £170.77 total cost

If your portfolio is bigger than the breakeven then you’re better off in clean class funds.

Make sure you count any annual fees, platform fees, dealing charges and other costs that are relevant to you (perhaps dividend reinvestment charges) and subtract any rebates. Remember to add the cost of multiple accounts if you hold them.

If you invest regularly then you should be able to accurately estimate your annual dealing fees, or else use last year’s pattern. You may also want to estimate your portfolio’s size once you’ve dripped another year’s worth of cash into it.

In for a percentage

Some post-RDR brokers charge a percentage management fee. For example, Charles Stanley Direct charges 0.25%.

That’s pretty simple. Just add that number on to your clean portfolio’s total OCF to see if the total cost is cheaper than the dirty version.

For example, an unbundled 0.24% + 0.25% is never going to be beat the bundled 0.37% fee for the dirty Slow & Steady portfolio.

To compare a flat rate fee against a percentage fee then use the following calculation:

Total costs of broker 12 divided by broker 2 percentage rate

= breakeven point

I’m outta here

If you do decide to switch then make sure you’re aware of the pitfalls of being out of the market if you cash out. Also note that your existing execution-only service may charge you exit fees to leave.

Some investors will be experiencing compulsory conversion to clean class funds, as their broker weans themselves off their commission skag.

But it is uncertain whether the commission-only escape route will remain open for long.

The FSA will rule later in the year on whether execution-only platforms will remain exempt from the RDR ban on payment by commission.

The fact that many firms haven’t gone clean is proof positive that the decision could go either way. Until then, where there’s muck there’s brass.

Take it steady,

The Accumulator

1. You can now get a clean version of the L&G Global Emerging Markets tracker. [↩]
2. Minus any flat rate costs of broker 2. [↩]

Good reads from around the Web.

Larry Swedroe is one of the best investing writers on the Web. He also writes books, and this week saw a chapter from his clever new one published on the Net.

The piece makes super reading for anyone interested in building simple passive portfolios that seek to capture the returns from various asset classes.

So that’s most of us around here, then!

The case for diversification

We’ve several times explained how simple asset allocation can improve returns and reduce risk.

Unfortunately, hunkered down here in our urban hideaway, surviving on scraps of the Financial Times that fall through the gratings and tuning to the BBC World Service for business updates on our homemade crystal radio, we don’t have access to the industry-strength databases to prove it.

But Larry Swedroe does, and his step-by-step run through building a portfolio on CBS MoneyWatch is clear and persuasive.

Swedroe notes:

Because most investors have not studied financial economics and don’t read financial economic journals or books on modern portfolio theory, they don’t have an understanding of how many stocks are needed to build a truly diversified portfolio.

The answer is a lot. The solution is funds containing hundreds, and as we know the most effective funds to plump for are cheap index funds.

Simply the best

From there, beginning with a classic 60/40 portfolio – that’s 60% in equities and the rest in bonds – Swedroe builds several different portfolios, and shows how they would have performed from 1975 to 2012.

The funds chosen are all US-based and aimed at US investors, but the principles hold true here, too, and lie behind our own Slow & Steady Passive Portfolio, which naturally employs UK funds.

Importantly, Swedroe doesn’t finesse his asset allocations. There’s no “Next we add 3.32% of small cap stocks, as that’s been found to be the optimal percentage to maximise return” nonsense.

I’d be sceptical whenever you see anyone presenting ‘proof’ that you should put 2.33% in Spanish equities or 1.72% in the utility sector or anything like that.

This sort of fine tuning reveals that they’ve mined a database for specific and unrepeatable outcomes in the past. It tells you little about your future.

Instead, favour logic and simplicity over spurious accuracy.

Swedroe concludes:

Through the step-by-step process described above, it becomes clear that one of the major criticisms of passive portfolio management – that it produces average returns – is wrong.

There was nothing “average” about the returns of any of the portfolios. Certainly the returns were greater than those of the average investor with a similar stock allocation, be it individual or institutional. […]

By playing the winner’s game of accepting market returns, you’ll almost certainly outperform the vast majority of both individual and institutional investors who choose to play the active game.

Simple really is clever when it comes to investing.

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