Mortgages are one of the less fashionable dinner table conversation topics. Yet without it, most of us won’t have a roof over our heads. Due to its longevity (a typical mortgage lasts 20-25 years), you want to get it right as otherwise, it’ll cost you lots of unnecessary £$.
I have just refinanced my mortgage. In layman’s term, it means asking another bank to pay off your existing mortgage and move onto the new bank’s product. I hope to illustrate why you should not only consider taking on a mortgage but actively seek to optimize it through refinancing.
Why a reasonable debt level is good for your finance?
I was raised in a culture which attached viewed debt negatively. The philosophy at home when I was young was “never get into debt or it’ll ruin your life”. That’s why my parents contributed to my university education and wanted me to avoid taking on student loans at all cost.
Yet as I became better versed with personal finance, I started to question that very premise and realized that a reasonable level of mortgage debt is not necessarily a bad thing. In fact, in the right environment, it can be great for your net worth.
1. Mortgaging is great when rates are low
We millennials may have entered the world shadowed by the aftermath of the Great Recession. It’s a scary world where employment is less secure and wages stagnate. However, it’s also a world of quantitative easing and drastic interest rate cuts.
The result is that we have been (and still are) in an era of ultra-low interest rate.
This is great news if you want to get a mortgage.
My previous mortgage had a rate of 1.4% fixed for 2 years. At the time of writing, the highest yielding termed deposit account in the U.K. offered a rate of 2.3%. This means that theoretically, you could borrow £10,000, deposit it into the savings account and generate £90 of risk-free profit every year!
When money is so cheap, there’s no reason not to leverage off other people’s assets to realize your dream, especially given the next reasons.
2. Mortgaging can provide buffering against inflation
Most folks balk at the word inflation. To them it means things becoming more expensive and the purchasing power of their money declines.
Not if you owe people money.
Unless your interest rate is linked to an inflation index (I haven’t heard of such product yet), then the interest payment will not be impacted by inflation. Better still, in the current low-interest climate, the interest rate is usually lower than the inflation index. Assuming your wage rises in line with inflation, it means that your purchasing power relative to the cost of servicing your mortgage is on the rise. This is very good because you’ll see a rise in your discretionary income.
The best time to have a mortgage is bizarrely in a hyperinflationary environment because the nominal value of the loan will simply be wiped out.
Imagine if you had a £200,000 mortgage against your property. At 100,000% inflation (experienced by a series of countries historically), your £50,000 per year wage will suddenly become £50,000,000. You can pay off your mortgage in less than a month!
Of course, this is purely hypothetical as there will be WAY bigger problems to worry about when inflation hits that level, but it’s simply to illustrate the inflationary buffer mortgage provides.
3. Mortgages can amplify your wealth
Imagine the following situation: you have an investable capital pool of $100. There are 2 investment options available.
- Invest in a property priced at $100, which yields 3% and grows at 3% per year.
- Invest in shares of a blue chip company priced at $10 per share, which yields 2% and grows at 4% per year.
- Invest 50% in shares and the other 50% in the property. Assume that you can reinvest your equity income but not your rent. Also, assume that you can take out a mortgage up to 50% of the value of the property at 3% per year.
Which option should I go with?
Why only invest in 1 asset when you can have 2?
As you can see above, by taking out a mortgage against the property rather than buying it at its full cash value, you can free up the remainder 50% of your own cash and expose it to a different asset class. Better still, the return of equity is higher than both the cost of borrowing and the return from the property (opportunity cost). This will give you real capital growth.
The benefits are clear: your money will be more diversified which reduces volatility and improves return.
Why you should remortgage?
Remortgaging is the replacement of an existing mortgage (or an unmortgaged property) with a new one.
There are primarily 2 reasons behind remortgaging:
- It liquidates capital tied up in the form of equity in the property, which enables you to deploy the fund in more appropriate asset classes.
- It redeems your existing mortgage and moves it to a better alternative (cheaper rate or longer teaser period).
Personally, I’ve been through both. A few years ago when interest rates were even lower than today, I remortgaged one of my properties at 1.4% and released the equity in the form of cash. They became the deposit of another property. Last month, when the teaser rate period expired. I remortgaged again onto another product at a higher rate (2.5%), but instead, the teaser rate period is fixed for 10 years as supposed to 2.
Think about it. Borrowing at 2.5% fixed for 10 years. This is a pretty good deal, especially given that I expect the interest rate to rise in the future.
Key things to consider before remortgage
Mortgage application is one of those archaic businesses whose complexity vastly exceeds the simplicity of the product itself. As a result, it’s imperative to get your house, in order to maximize the chance of success and be able to take advantage of the benefits above.
I’ve put together a list of areas that you might want to look out for.
- Loan-to-value Ratio: this is the amount of loan as a % of the value of the property. The higher the number, the greater the risk a lender faces because the buffer against a drop in property price is reduced. Try to keep it below 60% to get the best rate.
- Declared income: your income directly affects your affordability of the mortgage repayment. Lenders normally will lend you up to 4.5x of your annual gross income. Different lenders prefer different income types. Some want exclusively your wage whereas others can work off investment and other incomes declared on your tax return.
- Early repayment charges (ERC): most lenders will levy a penalty if you want to redeem your mortgage (either through payment by yourself or remortgage) within the fixed rate period. This is called the early repayment charge (ERC) and it can be anywhere between 1-5% of the outstanding loan value.As a general rule of thumb, try to coincide the redemption date to the expiry date of your fixed rate to avoid the ERC. The only time when you might want to bite the bullet and swallow the ERC is when you expect the rate to rise drastically and imminently. In reality, such occurrence is so scarce that paying the ERC is rarely justified.
- Other fees and incentives: there’s usually some other associated costs with the mortgage. Lenders may charge you an application/product fee. Some may also charge for property valuation. If you use an independent broker, he might also charge you a service fee (he’ll also be paid a commission by the lender).On the other hand, lenders might offer incentives to entice your business, ranging from free conveyancing service to cashback or even preferential personal loan rates! Compare them before making the final decision. In most cases, the fixed rate and duration of that rate should be the overdriving factor in your decision because of compounding effect.
There are many mortgage comparison sites which scan across the market to find you the best deal.
- In the U.K., I’ve used uSwitch to prescreen mortgages and Seico or AFP Windsor as brokers. They all provided excellent service and delivered outstanding results.
- In the US, I’ve heard good things about Bankrate. Do give them a try.
Having an appropriate amount of debt in this low-interest environment can be a shrewd move to improve the health of your personal finance. The most important thing to remember is to ensure you can afford the payment, protect your downside (through income protection insurances) and always be looking out for the best deal!