Things are looking up for investors. Not because the markets have got off to a strong start in 2023 – the gains logged so far could reverse in a day – but because the pain of 2022 has set the stage for higher future returns.
This is often overlooked during a bear market, probably because those paying the most attention have already invested a decent sum of money. It hurts to see it hammered.
In contrast, those 20- and even 30-somethings who most benefit from the falls have often yet to realize they need to invest for the future. And they aren’t paying attention!
Or, if they are putting money into a workplace pension or similar, for many the sums at stake won’t seem life-altering or worth the headspace.
But those of us who understand compound interest know better.
Let’s say a 30-year old has amassed £50,000 in global equity tracker funds across their tax-efficient pensions and ISAs.
Assuming the future looks like the past in terms of returns, say 8% annualized, their pot might compound to around half a million pounds after 30 years – with no further contributions.
Perhaps if you told them that their future self had a future half a million quid on the line, gyrating with the markets whims during 2022, they’d have been more interested?
Probably best you didn’t.
I get knocked down, but I get up again
Back to 2022, and recall that those who can save meaningful money typically do so throughout their lives.
Let’s assume for the sake of simplicity that our young-ish saver adds another £5,000 every year to their initial £50,000 pot from age 30.
At the same rate of return, adding £5,000 a year, they should end up a millionaire by 60.
(Yes, a million will be worth a lot less in 2052, due to inflation. Trust me you’d still rather have it.)
In this case they’d already saved £50,000 by age 30. But over the next 30 years they’ll save and invest another £150,000 in our simplified illustration.1 Most of their earnings and savings are ahead of them.
For anyone in this position, market falls are good news. They lower the price of new purchases. Which in turn improves the odds of higher future returns.
Let’s assume the 30 years of £5,000-a-year saving came after a 20% bear market that took their initial pot down to £40,000 – but that future returns would afterwards be 1% higher. In this case they would end up around 14% better off than if the bear market had never happened.
Again, all very over-simplified. Some mathematically inclined readers are cross I’m using arithmetic returns and a compound interest calculator, others that I’m not belabouring sequence of returns risk, that I’m suggesting that a mere 20% correction would juice returns for three decades, or that I’ve talking about nominal rather than real returns.
Yes yes. This is a friendly illustration you can enjoy with a cup of coffee on a Saturday morning, not a dissertation. Besides, even if I wrote 5,000 words it wouldn’t change the point.
Which is that falling prices are good when you’re putting more new money to work – whether you’re buying a house, a hamburger, or another dollop of your fav index tracker.
Vanguard expected returns
So what kind of future returns can we expect from here?
Nobody knows in the short-term, but industrial-strength modelling can give credible ranges of probability over longer time frames.
Which is exactly what fund behemoth Vanguard has done for equities:
Sorry about all the small print clutter but it seemed best to include it – you know what giant corporations are like.
Remember too that these are expected returns, within ranges of probability. Note the outliers. Nothing is certain.
With all that said, these expected returns are much higher than what Vanguard was forecasting a year or two ago. Especially for fixed income.
Tubthumping
I doubt that after a terrible couple of years for bonds, the average investor would think that UK gilts are likely to deliver 4.3% a year over the next decade?
Again, these are all nominal returns. For sure if you believe inflation is going to stay above 10% for the next few years then you shouldn’t touch bonds with a barge pole.
However me and more importantly most economists think we’ll be back down around the Bank of England’s 2% target in a couple of years, if not before.
Enjoy that thought, the other links below – and the weekend!
p.s. Want more expected returns? GMO did a good job calling the 2021 exuberance. Here’s its new forecasts [PDF]. Note these are real returns this time.
Thanks for reading! Monevator is a spiffing blog about making, saving, and investing money. Please do sign-up to get our latest posts by email for free. Find us on Twitter and Facebook. Or peruse a few of our best articles.
In practice the amount they save would usually rise at least with inflation, and often far more with raises. [↩]
Today we’re kicking off our monthly interviews with Monevator readers who’ve achieved financial independence and/or early retirement (aka FIRE). In this debut episode, Mark Greene explains how a pretty conventional work-life and a lot of saving and investing unlocked an early and unusual retirement for himself and his wife. We hope it inspires you.
Also, I want to give a quick shout out to ESI Money, whose interviews with US millionaires inspired this series.Do check them out!
Okay, let’s get this show on the road – appropriately enough, as you’ll see…
A place by the FIRE
Hello Mark, thanks for sharing your life story with Monevator. To start with the basics, how old are you and yours?
I’m 51 and my wife is 57. We’ve been married for 28 years.
Do you have any dependents?
We never had children, and each have one surviving parent – mid-70s and mid-90s. Both are living independently at present and are not hugely reliant on us. Long may that last!
Whereabouts do you live and what’s it like there?
Since early 2020 we’ve been traveling. Most of the time we have been in our own motorhome. At present I am near the beach in the south of France, and it is very pleasant!
Did you have any second thoughts about FIRE – or traveling – given a global pandemic kicked off right at the same time?
If we had known the pandemic – and particularly the travel restrictions – were coming, it’s probable we would have delayed stopping work. That said, it suited both of us to have missed the ‘pivot the way you work’ that everyone else went through in the spring of 2020.
I’ve never had second thoughts about not working, but retiring early to travel was the main motivator for stopping work for my wife. She found the first few months under lockdown hard.
Now though, no regrets on either side!
When do you consider you achieved Financial Independence?
We retired in early 2020. I was 48 and my wife was 55. So I guess that was when we consider we reached financial independence. Whether our pot could have been considered ‘enough’ before there could be a point for discussion, but we worked to a particular date, rather than a particular amount – which we hope is more than enough.
My wife has done some very limited freelance work since, mainly to stimulate the brain than for the money.
I haven’t worked since. We have been filling our time with traveling, when allowed to do so through the pandemic.
Assets: only a little bit racy
What is your net worth?
We currently have about £1.1 million in investments, plus our house which is valued at about £600,000.
What are the assets that make up your net worth? Any mortgages or other debts?
In general terms, our main assets are:
One SIPP (invested in a range of stock and bond funds) £330,000
Three ISAs (invested in funds and many individual stocks) £635,000
One of us also has a small government pension due at 60. It’s worth a few thousand a year.
We have no mortgage or debts, other than current month credit card bills. These are paid off every month.
What was thinking behind the peer-to-peer investing?
Peer-to-peer was a way to diversify my asset allocation, chase a bit of a higher return, and to experiment with something new.
Tell me more…
Initially it was Funding Circle, which I was a big fan of until about three or four years ago. They diversified the loans automatically to spread risk, it was automated, and it provided good returns.
Funding Circle has switched off retail investors though, and now I’m just running down the balances as loans get repaid.
Crowdstacker was less liquid and very hard to diversify. A couple of loans defaulted and whilst supposedly asset-backed, the platform has had some real struggles realising value from the assets. Credit to Crowdstacker, I think they have managed it brilliantly, but I don’t expect to see much of those loans back.
My other loans with Crowdstacker have performed perfectly well though. I achieved rates of about 7% when the banks’ rates were under 1%.
Property Partner is another innovative finance platform. My investments are made into numerous companies that hold property and take capital gains and rental income, distributing dividends along the way. I really like the platform, and it affords me exposure to property (other than our former home) in a diversified way.
The property market has suffered through the pandemic. But again I’m very happy with how the management of the platform have handled it.
So much for digital property holdings – what about your main bricks-and-mortar residence?
Our former home is an Edwardian three-bed semi in a somewhat rural location in the Home Counties, near a commuter rail station. We own it and it is currently rented to a tenant while we travel.
Do you consider your home an asset, an investment, or something else?
While we are not living in it, we consider it an asset as the rent provides some of our income. Once we return to living in it, I would consider it part asset – as it has value – and part liability – because it costs money to live in.
Earning: doing it the traditional way
Tell us more about your old job…
I was in business consultancy and my wife was in training – of adults for professional exams.
Before this we both worked in local government jobs for a few years. That said, we had both done our last jobs for around 20 years when we retired.
…and your annual income?
Mine varied according to the success of my consultancy – I was self-employed – but probably averaged to about £60,000 of annual salary if it were a normal job. My wife was on a salary, which was about £80,000 at the end.
We have no formal income now. We live off our assets!
How did your career and salary progress over the years – and to what extent was pursuing financial independence (FI) part of your career plans?
We both switched careers and then progressed in earnings terms, though neither of our jobs had a traditional career ladder involving promotions and so on. For a few years my wife reduced her working hours slightly – and sacrificed salary – for a better work-life balance.
Other than seeking to maximise earnings in order to grow our assets, pursuing financial independence didn’t directly influence our plans.
Did you learn anything about building your career and growing income that you wished you’d known earlier?
We realised part way along the journey that it was better to work and earn less but stay sane, rather than go all out for a big income and suffer stress and other effects.
We delayed our FI date by a few years so that we could temper our workload – and spend a bit more on holidays – on the way.
Did you have any sources of income besides your main job?
No, we didn’t. We’ve had no significant sources of money other than our work – no side hustles and no inheritances.
Did pursuing FIRE get in the way of your career?
No, never. In fact the mental discipline required to plan for financial independence, and then execute on the plan every month, proved beneficial when applied to our professional careers too.
Saving: starting with an awesome budget
What is your annual spending? How has this changed over time?
Our baseline budget is just under £40,000. This goes up if we are on a major travel trip, but it’s all planned for in our mother-of-all-spreadsheets.
Do you stick to a budget or otherwise structure your spending?
Since we met 34 years ago, my wife has operated an awe-inspiring level of structure in our spending, so we have always budgeted and have always stuck to it. We allocate so much a month to various buckets of spending – food, drink, going out, bills, and so on – which smooth out big bills over the years and has allowed us to ensure we don’t spend on things we don’t really need, whilst still enjoying life.
What percentage of your gross income did you save over the years?
I have to say, I don’t know. It was lower when we started out as we earnt less and had a mortgage, but we never recorded what it was.
This was way before the days of the FIRE movement and an understanding of such numbers. We just saved as much as possible after we had funded the basic budget mentioned earlier. This meant any bonus, pay rise or a bumper year for my consultancy went into the FI pot – not on vanity purchases.
What’s the secret to saving more money?
My first ever financial advisor told us to find a level of life we were comfortable at, and then stick to that budget even if we earnt more, and to save the rest. That was arguably the best advice I have ever been given. In life and business we strove to spend less than we earned and to use the rest to grow an asset base.
I have also tracked our net worth for well over 20 years. Seeing it gradually increase as we paid down the mortgage and grew our investments was a good motivator to keep going.
Do you have any hints about spending less?
The game changed for us when we decoupled from the materialistic societal norms we are all surrounded by. The less we watched TV, read weekend newspapers or monthly magazines, the less we were exposed to ads telling us we would be happier if we only spent on X, Y, or Z.
Whilst all our peers were buying bigger houses, more cars or funding expensive hobbies, we were focusing on what we valued, which didn’t cost money – time together, simple hobbies, and so on.
Oh, and don’t have kids! That turned out to be a significant factor in our story.
Do you have any passions, hobbies, or vices that eat up your income?
Retiring early to travel in a motorhome like this was a big motivation.
Our one guilty pleasure has been travel, which we have spent a lot on over the years. That said, we tend to travel cheaply – not backpacking, but definitely not five-star hotels and big meals out – so we can have a lot of experiences for what we spend.
We have banked some unbelievable memories from that spending.
Investing: starting outside a pension for early access later
What kind of investor are you?
My financial education started with the original Motley Fool in the mid-1990s, and then was influenced by Warren Buffet. So I have been primarily a buy-and-hold investor.
I started with managed funds, then moved into trackers as they became available and online trading became a thing.
For many years I did choose my own stocks. I’d buy in chunks of about £2,000 and try to build a diverse portfolio – although all were in the UK. Some were stars, and many were dogs…
Over the last ten years, as I learnt more and as the products developed, I have sought to consolidate into passive tracker funds. I’m a big fan now of Vanguard’s LifeStrategy funds.
What was your best investment?
In terms of headline percentage return from specific buys, Games Workshop, Novo Nordisk, and Unite Group have been big winners. But the actual return has hardly been life-changing.
Arguably my best investment decision was made firstly at 22 when I decided not to have a pension and invest in funds instead – so that I could access it early – and then a few years later deciding to manage it myself rather than through an adviser. That has made a huge difference in terms of that compounded percentage return over two decades of investing.
Can you tell us more about that decision not to invest in a pension?
When my decision not to have a pension was made in the mid-90s, SIPPs were never raised – even though they existed – and I’m not sure I knew enough to manage it all then. They were also not accessible at 55 at that time. And I knew I wanted the option to retire early, because of the age difference with my wife.
Once I had embarked on the ISA path, I just stuck with it for me – even when we were putting a lot into my wife’s SIPP.
Did you make any big mistakes on your investing journey?
If I had my time again, I would buy tracker funds from the off, not individual stocks. It was interesting to do, and made it partly a hobby. But for every tenfold grower like Games Workshop, there’s a total wipeout like Carillion or Laura Ashley.
As I mentioned earlier I also made some peer-to-peer loans that were in theory asset-backed, but were not immune to alleged illegal practice by company directors. I’ve mentally written off the loan, but court proceedings are continuing.
That bit where they say “you may not get your capital back” is there for a reason!
What has been your overall return?
My best guess would be an annual return of 4%, though I think it is probably a bit more. This includes keeping a reasonable amount in cash – over 20% of the portfolio – when interest rates were almost negligible, because we were approaching retirement. We wanted the security of knowing we were safe from sequence-of-returns risk in the first few years. It was also kind of handy when Covid broke the month we retired and the markets dropped 20%!
Listening to my own answer it strikes me that 4% doesn’t sound too great… But I have another rough calculation that suggests we more than doubled what we put in, partly through pension tax relief but mostly through compounding, because we’ve been doing this for over 20 years.
How much did you fill of your ISA and pension allowances?
Until we retired we filled our ISA contributions every year for most of the years. That – and compounding – is how we have amassed over £600,000 in ISAs.
I don’t have a pension at all so I never benefited from pension allowances. My wife has a SIPP. In the last few years of her working we maximized the contributions (including backdating) using cash we had accumulated.
That immediate uplift as a higher-rate tax payer is the best return we have ever had!
To what extent did tax incentives and shelters influence your strategy?
The tax rebate on the SIPP definitely influenced our decision to pour money in there in the last few years of working. Although the SIPP is just a wrapper, and the money would have been invested in the same thing in an ISA or in the pension.
How often do you check or tweak your portfolio or other investments?
Overall, I do a full evaluation every month, and have done for 30 years. This enables me to report our position to my wife, and to ensure I have an eye on the performance of individual investments.
In addition, I have a reasonable amount of our portfolio that I use to day trade on the ups and downs of the FTSE 100. This is my non-passive guilty secret!
Because of this part of the strategy, I am prone to checking the FTSE more than once a day. But I only ever do this around what we are already doing for the day.
Sometimes we will be off-grid and I don’t check for a week or more.
Wealth management: making it last
We know how you made your money, but what about keeping it?
The meeting of the two systems used by my wife and I enabled us to keep it.
My long-term spreadsheet and the plan to grow from nothing to our nominal £1 million retirement pot, coupled with her monthly budget and accessing only money available for planned spending meant we overcame the temptation to splurge or to fritter it away.
I was passionate about becoming financially independent and retiring early. That drove our behaviour every month, every week, and every day.
Which is more important, saving or investing?
Well, that depends what you mean by both terms. I see saving as money in the bank, investing as more risky options like funds or stocks. Saving is the essential first discipline, but bank interest rates will not grow enough to retire early. You need to take more risk and therefore invest.
When did you think you’d achieve financial freedom – and was it a goal with a timeline?
I thought it would be in my 50s. But then as the plan developed it became clear that with a fair wind it would be possible before that. The main driver was my wife’s age (she’s older), but I am proud to have got there in my 40s.
For the last ten years or so – once it was a clear goal with a very clear timeline – I told a LOT of people about. We really committed ourselves to it.
Did anything unexpected get in your way?
I’ve invested through three big recessions and crashes, though arguably that was expected – if unwanted – over a 25-year period.
Our life wasn’t without challenges, but from an investing sense nothing really got in the way.
Are you still growing your pot?
As we don’t have kids, our spreadsheet allows us to de-accumulate. But that could stretch out over a 50-year time frame or longer, so I am currently trying to maintain the pot.
With our spending heavily front-loaded so that we can make the most of retiring early – and with the tough market conditions since 2020 – that hasn’t always been easy. But we’re not too far off plan!
Do you have any further financial goals?
Ensuring the pot lasts long enough to pay the funeral bills, and not a moment longer. Who knows how far in the future that will be, so in the meantime I seek to do as well as I can with the assets we have accumulated. The targets are in my spreadsheet!
I genuinely wish Monevator had existed when I was in my 20s. There is so much more information available now, and it is so much easier to do with online platforms. My investing journey started before the internet.
A danger is though that one can spend too much time reading and learning, and not getting started.
Compounding is our greatest friend so, however small, start straight away and keep learning. Read and absorb and improve your strategy as you go.
Learning: starting young, headed to 100
When did you first start thinking seriously about money and investing?
At 22, when I took my first job and had to decide whether to have the company pension or not.
Did any particular individuals inspire you to become financially free?
My father was terrible with money and I didn’t want to be like him. I wanted the security of knowing I need never work again and I could live. That has always been my driver – because life is too short to waste working, even if you enjoy it.
Can you recommend your favourite resources for anyone chasing the FIRE dream?
Genuinely, Monevator! I think it is excellent and strikes exactly the right tone
If your only source of information – other than detailed personal tax and pension advice – was Monevator, you’d probably do well.
I am also now a massive fan of the Vanguard Life Strategy funds – inexpensive, easy to manage, and they take away the risk of paralysis by analysis. Rather than wasting hours optimizing the perfect asset allocation, trust Vanguard and spend the time earning more, learning more, or just enjoying your family.
Based on my own experience, I would work with a quality business or life coach to understand and plan what you really want from life and how you want to make it happen. The clarity that coaching gave me, on many occasions, changed my life.
What is your attitude towards charity and inheritance?
Being charitable is not just financial. I am intensely aware of our good fortune, and we have a budget (of course!) to make donations that help others.
We also now have the luxury of giving our time – either to support people we know, or to help organisations that have a broader impact. My life plan includes some form of major charitable service after we’ve finished traveling too.
Like everyone should we have also written our wills and they provide for charitable donations and inheritances for people we know who would benefit. We don’t have kids, so I guess we have less societal conditioning about who we leave our wealth to.
What will your finances ideally look like towards the end of your life?
Our plan allows for the money to last past our 100th birthdays. But the one thing I know for sure is that life never perfectly follows your plan.
We intend to enjoy the next 20 or 30 years as much as possible, and then anticipate a slowdown, but with enough funds to still enjoy life. If we go early and our beneficiaries gain, then so be it.
My dislike of the fees charged within the financial sector means we will probably avoid any managed products like annuities – but never say never. I enjoy learning about money and managing our finances, and I hope I have the acuity to do so for a very long time.
I guess the dream remains to have a wonderful life (which we do) without diminishing the pot.
So there you have it readers! FI by 50 and retiring early to travel and enjoy life on the road with his wife while they’re both young enough to make the best of it. Questions and reflections – on the concept of these FIRE-side interviews generally or on Mark’s journey specifically – are welcome below. But please do remember Mark is not a hardened Internet warrior like me and he is just sharing his story to inspire others, not to feed the trolls. Of course you can disagree constructively, but please keep that in mind. Thanks!
How often do you check your portfolio, or even calculate your net worth? And how do you do it? Inquiring minds want to know. By which I mean your fellow Monevator readers!
The topic came up in a recent comment thread about end-of-year reviews. We decided a reader poll might be of interest.
Of course in theory I agree with my blogging buddy Nick Magguilli, who warned this week that most people’s time is better spent working for an income rather than fiddling with their investments:
Assume someone with $10,000 invested spends 10 hours a week doing stock research looking for the best investments. Let’s also assume that their research is good and they are able to beat the market by 10% a year as a result.
While this is impressive, unfortunately, their 520 hours of work (10 hours per week * 52 weeks per year) only netted them an additional $1,000 (10% alpha * $10,000). This means that our star analyst was doing stock research for under $2 an hour ($1,000/520 hours).
If the analyst’s ultimate goal was to build wealth, you can see how they would’ve been far better off by picking up a part-time job instead of analyzing 10-Ks.
Even if we were to increase the analyst’s portfolio size to $100,000, their 10% alpha (i.e. $10,000) is roughly equivalent to what they could have made driving for Uber in the same amount of time.
Guilty as charged Nick, at least for the past nine years.
Also, I suspect ten hours spent on investing matters a week is a big underestimate for active investors. It certainly is in my case.
On the other hand it’s good to have a hobby – even a passion.
For my part, my interest was what made saving and investing as much as 50% of my income more like an exciting prospect than a sacrifice. I was simply buying more firepower to do what I loved – the way somebody else might buy new golf clubs.
On the other hand, I don’t really any career to speak of. And given my passion, it might well have been better to get a job as a junior analyst while I still could and then to work my way into running money. (But… wearing a tie. The horror!)
Anyway, I can see both sides.
The poll tax
Hopefully my musings haven’t queered the pitch too badly. Please answer the polls based on what you do – not what you think you should do!
Below you’ll find two questions. Select the answer that’s closest to your own habits.
Yes, I understand some responses aren’t mutually exclusive, or that the poll does not reflect your unique and special experience.
Mine neither. That’s the nature of broad brush polls! We’re just after a sense of how Monevator readers mind what’s theirs, in aggregate.
For instance, I check my portfolio more-than daily via a real-time spreadsheet, but I also do occasional reviews in a text document. Clearly the first best describes how I keep tabs on my portfolio, right?
Two questions, no wrong answers
Firstly, let’s hear how often you check in on your portfolio.
I don’t mean attending to administrative matters (say an email from the platform) or adding money (automatic or manually) but rather keeping tabs on the (hopefully) growing value of your stash.
Secondly, readers and I were curious how you do it.
Again – there’ll be crossover. For example I run a massive real-time spreadsheet, but of course I sometimes see elements of my portfolio on a platform’s web page. Who doesn’t? So the spreadsheet answer I’d give here.
Thanks in advance! The poll will run until Friday and I’ll either recap the final results next weekend or riff them into a future article.
Have a great weekend.
p.s. The new Netflix documentary Madoff: The Monster of Wall Street is worth getting in the supermarket popcorn for. The first episode in particular offers a potted history of 20th Century Wall Street. As for the story, it’s completely unbelievable. Which is crazy, considering it’s true.
Do you have a mortgage? Do you know what your loan-to-value ratio is – and what interest rate band that puts you into with your bank?
Oh, I see… You have other hobbies.
Look, I appreciate there’s nothing more boring than a mortgage deal. Especially when half of you already know what I’m talking about, and will nod off in about 150 words’ time.
But if you don’t, please keep reading. You might save yourself a lot of money.
Just ask Richard, a first-time buyer.
Richard was stretching to buy his first flat. And because I’m the sort of person who has blogged about money for 17 years, I asked him what his loan-to-value was.
“Huh?” said he.
Long story short: by releasing an extra £2,000 from an ISA he’d mentally segregated for something else, Richard could reduce his total mortgage repayments over the next five years by over £8,000.
That’s a 300% return on the extra £2,000 he put down!
What is the loan-to-value ratio for a mortgage?
I’ll say upfront: this is a particularly extreme example. Richard is arty, clueless with money, and rarely reads a menu let alone the financial small print.
What’s more Richard was set to borrow at his bank’s steepest rate for first-time buyers, before he found that extra money down the back of the metaphorical sofa. The savings will rarely be so big.
Nevertheless the principle holds for all mortgages.
And personally I’d rather have any extra money, however tiny, if the alternative is it goes to a bank.
So what’s going on here?
Well, it starts with the loan-to-value (LTV) ratio of your mortgage.
The LTV ratio is simply the ratio of what you’re borrowing from the bank – the mortgage – compared to the purchase price of the property.
For instance, say you’re buying a home that costs £400,000 and you’ve got a £100,000 deposit. You’ll need a £300,000 mortgage to complete the purchase.
That is a LTV ratio of £300,000/£400,000, which works out at 75%.
Or say you have a mortgage of £270,000 on a £336,000 property.
The LTV ratio is £270,000/£336,000 = 80.35%
As we’ll see in a moment, those pedantic two decimal places are the whole point of this article.
But first a quick detour into why banks care about LTV ratios.
Loan-to-value ratio and riskiness
Although it remains hard for those of us who lived through the financial crisis to believe it, banks are in the business of managing risk and return.
And mortgages are the least risky debt – for both banks and borrowers.
That’s because mortgages are secured loans.
The property being bought is put up as collateral by the borrower. If you don’t meet your mortgage payments, then your bank can seize and sell your property to cover the mortgage and recoup what it lent you.
This clearly makes a mortgage a safer form of debt for the bank, because it is asset-backed.
But it’s also safer for you as a borrower. The rate charged on an asset-backed mortgage will be much lower than that on a credit card or a personal loan.
Less risky does not mean risk-free. A mortgage is still a big liability, and you can lose a lot of money if things go against you. All debt has downsides.
Of course, banks aren’t desperate to seize and sell their customers’ assets to get their money back. Partly because it makes for bad publicity, particularly when they’re all at it. But also it’s costly and time-consuming.
And most importantly – bad news tends to cluster.
The very time when a bank’s borrowers are defaulting en masse on their mortgages will invariably be a terrible time for the economy more widely – and probably for house prices, too.
Banks could be seizing and selling properties into a falling market (as they did in the early 1990s).
Which means that in a steep house price crash, the bank could fail to recoup the money it had lent out against the mortgage when it sells. Especially once all the various costs are factored in.
And again, despite how it looked in 2008, banks don’t really want to be losing money on one of their main lines of business.
The loan-to-value ratio and interest rates
Obviously this unhappy loss-making outcome is more likely when the mortgage made up most of the money used to buy the property.
In other words – when the purchase was at a very high loan-to-value ratio.
In that case, the equity in the property – the difference between the house price and the mortgage – is very small. There’s not much safetly buffer, from the bank’s perspective. So little in fact that after a house price crash it could be wiped out and even go negative. (Hence the term ‘negative equity’.)
To reflect this risk of losing money on small deposit house purchases, banks charge greater interest rates on their higher LTV mortgages.
At the very highest LTV levels – where the borrower puts down just a 5% deposit or maybe nothing at all – rates will be far higher than for borrowers with a chunkier deposit who borrow from the same bank.
Banks typically obfuscate all this with their mortgage filters and other tools. But a few do make it admirably plain via downloadable lists of all their products.
Here the mortgage rate falls by 0.24% for buyers who put down an extra 20% deposit, meaning their LTV ratio is 65% compared to 85%.
On a £300,000 mortgage, that’d be a difference of £42 a month, or £2,520 over five years. Not enormous, but certainly worth having.
But the LTV bands in this example are very wide. You’ll find them stepping down in 5% increments with some lenders.
In my initial example, for instance, Richard was originally borrowing on a LTV ratio of 95%. His bank was looking to charge him 5.75% over five years.
By putting in a little more cash, Richard dropped to an LTV ratio of 90%. The interest rate in that band was a far cheaper 5.04%. Which was what made for the vast savings we saw over five years.
Mind the cliff edge
You might say this isn’t rocket science – and I agree, it’s not – and that if you had an extra 20% of the purchase price to casually reduce the size of your mortgage, you’d do it already.
Fair enough – but that’s not what I’m talking about.
The point is these LTV bands are arbitrary and typically pretty rigid.
Again, Richard he didn’t have to put down an extra 5% deposit to drop into the much cheaper mortgage bracket.
His deposit was already big enough such that his LTV ratio was only slightly above 90%. Putting in just £2,000 to get the LTV ratio below 90% is what unlocked a cheaper rate and saved a fortune.
The return on those marginal pounds was enormous, as I showed above.
Now, many of the sort of people who read Monevator will find this obvious. Which reminds me of my former housemate, Nat, who I used to compete with while watching Who Wants To Be A Millionaire?
Nat was never very self-aware about this – even when I pointed it out to her – but there were only two categories of questions in this quiz as far as she was concerned.
“Too easy, everyone knows that!” (when she knew the answer) or “Impossible, that is so obscure!” (when she didn’t).
Similarly, all this may be obvious to some, but others aren’t used to thinking about money this way.
In my experience people often have, say, a pot of cash for the house deposit, and another pot set aside for furnishing the property or for buying a car or simply labeled as nebulous ‘savings’.
Depending on how close to the LTV ‘cliff edge’ they are, it could make much more sense to add that money to the deposit, unlock a cheaper mortgage, and to then use say a 0% credit card to furnish the new home. (Provided they can trust themselves to pay it off, of course!)
Alternatively, they might employ removal boxes as furniture like I did when I bought, and gradually furnish their new home out of the cashflow freed up by the resultant cheaper mortgage!
A few final pointers about loan-to-value ratios
With so much financial business done online nowadays, I suspect a lot of people simply click through a mortgage comparison site with little idea about the loan-to-value ratios driving the rates their offered – let alone how much they might save by putting down a little bit more as a deposit.
So a few concluding thoughts about tweaking mortgage bands via the LTV ratio:
Can’t increase your deposit? Maybe you can get into a lower band by driving a slightly harder bargain when you buy your home. Remember it’s the ratio that matters.
Your loan-to-value ratio will have changed by the time you remortgage. A repayment mortgage reduces the size of the mortgage balance over time. If house prices rise your loan-to-value will fall further.
Also look out for any opportunity to nudge yourself into a more favourable band when you remortgage by making over-payments.
While we’re on the subject, these sort of cliff edges pop-up elsewhere in personal finance. So stay alert.
You’re looking for marginal edge cases, where a small additional amount of money or some other tweak to your financial posture generates outsized returns.
For instance, increasing your pension contributions can enable you to retain your child benefit if it reduces your income below the critical threshold – a win-win.
Paid to play
It’s pretty dopey these arbitrary bands with critical thresholds still exist for mortgages. Not to mention other areas like stamp duty – and arguably even income tax.
Simple bands made sense when everything was worked out with a slide rule. But what’s the justification now? It’s all done by computer.
Ideally each of us would be offered a bespoke mortgage rate. This would reflect every facet of our unique financial situation. Such individualized underwriting would be fairer on borrowers – and perhaps safer for the banks as well.
Maybe lenders worry that bespoke deals – or even just narrower loan-to-value bands, with say 1% increments – could confuse us? Or even lay them open to mis-selling claims?
Whatever the reason, for now it pays to pay attention to the small print.
Got a favourite example where some marginal additional pounds unlock outsized benefits? Please share all in the comments below!
