Your Networth, your mortgage, interest rate risk and Boris Johnson

There can be heated debate around whether or not you should include your residential property and mortgage in your Net Worth calculation.  As heated as it gets in the Personal Finance world.

Some Personal Finance bloggers brawling over the proper way to do a Net Worth calculation.  
I do two calculations, one with and one without.  Including it inflates your NetWorth, for what is an indivisible, very illiquid asset, that doesn’t generate any income and who’s capital is hard to access.  Not including it leaves a huge asset out of your NetWorth, which could make you sad.  There’s no clear cut answer here.

Buying a property, for most of us, means taking out a mortgage.  Essentially a very long term loan, the repayments of which are linked directly to the underlying base rate (even a fixed rate isn’t forever).

I struggle in the mornings not to put the porridge in the fridge, pour the milk on the flooor and then put the bin in the microwave.  Yet I took on a mortgage with barely a blink of the eye.  Locked into a huge loan with decades of uncertainty ahead.  It’s almost like I was conditioned to accept it as normal.

Value of interest payments
Our mortgage payments consist of an element of capital repayment (woohoo) and another of interest (boo).

Most of us know what our outstanding mortgage balance is, there or thereabouts at least.  Yet few of us are aware of how much we have yet to pay in interest to service the loan.  And it’s so easy to work out;

Total interest to be paid = (Monthly payment * number of months remaining) – Capital outstanding

It might not be a bad idea to include this somewhere, if you include your house in your Net Worth.  If nothing else, it’s a reminder how how staggeringly large the aggregated interest payments are.  And hopefully a small kick up the arse to make some overpayments.

Interest rate risk
Consider someone who purchased a £250k house, with a £200k mortgage at 2.5% interest.  We could show this like;

On the left we see the value of the mortgage in blue and the total of the future interest payments in orange.  On the right is the property value.  
On day 1 we are locked in, ready to pay more than the house is worth in repayments, even with a £50k deposit.  That’s the price of borrowing money from the big bad banks, you are simply a risk and potential profit to them afterall.  The house value will probably go up in the long term, and it’s certainly worked out pretty well for some historically and could still for others.  But still….
Same situation, but on day two the interest rates jump to 5%;
The increase in the value of the future interest payments is staggering.  From £68k up to £147k.    
Yeah, there’s a lot wrong with this.  It wouldn’t happen that quick, just looking at one variable by itself is daft as interest rates will be correlated with all sorts of things, house prices change, sugar is bad for you, blah blah blah.  
But your own portfolio, the You Incorporated, is exposed to some hefty interest rate risk.  Perhaps you have a cool £200k balance invested in bonds and cash to diversify away some of that risk.  I don’t.  
We could play around with the term of the loan and the interest rate and even come up with some sensitivities.  A 0.5% increase from a rate of 2.5% means an extra £15k in interest, or increasing the term to 30 years at a rate of 2.5% means an extra £15k in interest payments.  Unlike compound interest, negative interest is never good.  
We tend to view mortgages with affordability in mind, we look at the monthly repayments and our income in isolation, sometimes missing the much larger picture.  That horrific stream of interest payments streaking off into the future, a troupe of payments that is incredible sensitive to the underlying interest rate.
Low interest rates probably result in larger houses being purchased, rather than be used to hammer down an outstanding mortgage.
Including the value of future interest payments in your Net Worth

Including the future value of interest payments somewhere in our Net Worth, even as a foot note it can serve as a reminder of just how much interest we will pay, even in the current low interest rate environment, and perhaps how exposed so many of us are to movements in interest rates.

I’m saying nothing about the benefits of buying or renting, or about paying down your mortgage vs. investing in a low interest rate environment.  Simply how exposed I am, and the majority of people with a mortgage are, to interest rate movements.  Interest rate movements tends to be viewed along the lines of affordability… can my salary gobble up any increase in mortgage payments.  Once we are locked into the mortgage we almost don’t want to know how much it will cost us in the long run.

I doubt that including the total value of interest payments as a deduction to your Net Worth would ever catch on, most people want to increase their Net Worth, not decrease it.  Not to mention it would fire up any accountants beyond the point of no return.  “It doesn’t make any sense!” they would scream in between bouts of praying to the gods of double entry.

But to have the total value of the interest payments in one figure is a good shock tactic, even if only as a footnote to your impressive Net Worth.  I’ve added it to mine.

A reminder that one of the smartest moves is one of the simplest, pay off your mortgage completely and get rid of that footnote.  Investing might get you a better return in the long run, but paying down your mortgage quicker will save you money in the long run,  As ever, diversification is king, a combined approach is probably best.

The Portfolio Effect

It would make a less exciting film than the time travelling in The Butterfly Effect, but the impact of a mortgage on our portfolio is something worth considering.

You might have a mighty impressive £80k in equities and £20k in cash/bonds.  An aggressive 80/20 split.  But what if the house in the first example above is added to this…

£80k in equities, £20k in cash/bonds, £250k in property and £200k in a mortgage (a ‘negative bond’ position).

We could look at this with the mortgage set against the cash position  –  £80k in equities, £250k in property and (£180k) in bonds/cash.

So much for a diversified portfolio.  That’s a 53/-120/167 portfolio in equity/cash&bonds/property.  Pretty different.

Needless to say the impact of the property means the portfolio allocation is nowhere near the diversification we were hoping for.

Our residential property doesn’t generate any income, it is for us to live in, we don’t really care about the capital value if we plan on staying there.  So we could argue that it doesn’t need to be included in our Net Worth.  Yet the exposure to the loan, that negative cash position, has some argument for being included.

But we are skipping merrily along the borders of a completely different subject here, which I will leave alone.

I need to have a chat with Boris for mocking my idea.

Mr Z

5 thoughts on “Your Networth, your mortgage, interest rate risk and Boris Johnson

  1. Aspiring Franklin

    As a long time renter and recent buyer, I've chosen to view my property as a buy to let investment where I also happen to be the tenent.

    I would always have to pay someone for housing – it just happens that now this someone is me, allowing me to reap the gains.

    The tax advantages of owner occupied housing (no income tax on "rent", no CGT) make it the best BTL investment you can make.

    As you say, changing interest rates can have a big impact on returns, but this would be the case with any BTL investment. I don't see too many PF types excluding BTL equity, so why exclude your home?

    Also it makes me feel better, as the investment cupboard is quite bare at the moment!

    Reply
  2. London Rob

    Hey Mr.Z
    An interesting idea 🙂 We do keep a track of the amount owed and I know its an obscene amount of interest we will be paying back, but I actually couldnt tell you even roughly how much (significant lets just say that!).

    I spent a long time on the invest/overpayment choices. In the end I decided first port of call fill up the ISAs – so my ISA is filled up and divi's get reinvested, my other half's gets filled up then the income generated pays down the mortgage, if there is anything extra to go into savings (hahahahahahahahahahaha – right after 30k into ISAs?!) then I will put it into a dealing account, generate income, and that income will pay down the mortgage as well, lets see how it works out – I've already managed to knock a year or so off the original 27 year term!

    Cheers,
    London Rob

    Reply
  3. M from There's Value

    We're doing pretty much the same as LondonRob. I don't see why we should pay down the mortgage when we could be even Stevens with the mortgage owed after 11-13 years of investing in a diversified collection of assets…

    Reply
  4. theFIREstarter.co.uk

    Interesting idea Mr Z!

    I think it's worth having as a footnote as you say, but ultimately not worth actually *including* in your NW figure. It would just be too depressing for a start 🙂

    It also doesn't seem fair to have to include future payments on things. In that case why not include projected spending for the next 25 years and also projected income? Then the figure would look much rosier (for savers not spenders, at least) 🙂

    Reply

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