The principle of mortgage cost averaging
Hey guys,
I had an early morning review with one of my clients who was a little stressed. They were stressed that mortgages seemed to be going up and up and they’d have problems paying the mortgage if it didn’t stop soon. Logically, everyone knows that interest rates go up as well as down but it’s cold comfort during periods when all they do is go up.
Interest rates work in a cycle. They go up and up and then come down and down. Then up and up. Then down and down. So it’s natural that our perception of what they’re doing is more rooted in emotion than cold logic.
So my question to you is this: what can we do to smooth things out regardless of the market or cycle?
Use a Fixed Rate Mortgage
This is a simple way of securing a single rate, but may only last for 2 years (bear in mind that market cycles every 7 to 10 years). We do have longer term interest rates available but don’t forget: the greater the risk the greater the reward.
Mortgage Cost Averaging
This is the Set and Forget way.
I love taking other people’s solutions and applying them to my portfolio. This principle is called dollar cost averaging and I borrowed it from the share trading game. It basically says: you buy a packet of shares each month, regardless of what the market is doing.
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The first month they may be £1 per share and you have £10 to invest, so you purchase 10 shares. The next month they are £2 per share and you have another £10 to invest, so you purchase 5 shares. Now - and here’s the power of this principle - rather than think damn, I just bought my shares at double the price, instead think I have bought 15 shares at an average of £1.50 each!
When applied to property investing, mortgage cost averaging works like this:
- Pick the interest rate that you think will be the average over the market cycle. May I suggest 6% for the UK market. I actually work mine on 5.5%, but if you’re a little more cautious then choose 6%. Remember that this is the actual interest rate you will be paying on your mortgage — not the Bank of England base rate. Let’s call this the “MCA” rate.
- Work out all of your mortgage payments based on the MCA rate. It’s a simple equation:
(Mortgage owing * interest rate / 12) = the amount you should pay each month into an account.
- Now depending where you are in the cycle two things will happen:
- If the “MCA” rate is above the actual interest rate then you’ll have a surplus of money each month. This surplus should be paid into a provision account and will accumulate over time. Whatever happens - pay the full “MCA” rate and not the real rate.
- If actual interest rates are above the “MCA” rate then you’ll have a shortfall each month. Fund this shortfall out of the provision that you have built up. This is an crucial time because it’s when you’re most likely to start thinking that things are going bad.
The point here is by picking your own “MCA” rate that is around or just over the average interest rate for the whole period, you’ll take into account interest rate fluctuations over the entire period. Once you have done this, just switch off to all the doomsayers and economists and get on with living your life. You have now allowed for any changes in interest rates so don’t worry.
I have used this principle for a long time and it’s amazing how disinterested you can become about interest rates. I know — that, coming from a full time property investor and educator like me is something you thought you’d never hear. :-)
Live with passion,
Brett
PS. One final thing: if your MCA rate is higher than the actual rate and you are struggling to make payments then you need to seek some help and fast. Don’t stick your head in the sand and hope for the best. The earlier you catch and correct, the sooner you’ll sleep a full night. After all, investing is really about sleeping well. :)