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Why it pays to borrow when inflation is high and interest rates are low

Inflation as measured by the CPI Index reached 5.1% in the year to November 2021 (up from 4.6% in October) but the RPI Index rose to 7.1%. The Retail Prices Index is relevant to mention because it is the one inflation index that includes mortgage costs. This is the highest rate of inflation in the UK for 10 years.

The question is will inflation persist at these relatively high levels or go even higher? Also will interest rates rise more following the tiny increase in the base rate by the Bank of England from 0.1% to 0.25% on 16 December last month?

Whilst I do not possess a crystal ball it does look probable that interest rates will rise further and that a higher rate of inflation is likely to persist for some time to come. The longer the government takes to increase the base rate by a more meaningful amount, the more likely the pound will weaken which will further increase inflation because imports will become dearer. This appears to be the likely scenario being played out. Of course, the government will state that inflation is temporary and the base rate doesn’t need to be increased but that’s politics for you.

Having lived through the seventies when inflation averaged in the teens and the base rate rose to 17% I, for one, am never complacent about inflation and interest rates. I certainly don’t expect things to get as bad this time around but a rise in inflation and interest rates by a few per cent over the next year or two wouldn’t surprise me in the least. Bearing in mind that the base rate has averaged about 4% over the last 200 years, a return to that level is certainly not implausible.

So if you own a property and you have a mortgage the question is should you reduce or pay off your mortgage entirely if you can afford to do so? I would argue that now is not a good time to repay debt, especially cheap debt. For most people, the cheapest debt they have is mortgage debt. Mortgage deals can be obtained at rates of less than 2% p.a. currently. If you were to secure a mortgage rate of 2% or less for a 5 year fixed rate mortgage that would represent excellent value for money. This is on the basis that the money you could have used to pay off your mortgage is invested instead. By invested I do not mean in a bank account but in a fund or funds which are predominantly invested in equities.

Bearing in mind the dividend yield on the FTSE 100 Index of shares is estimated to be 4.1% for 2021 before factoring in any capital growth, it is hard to imagine how you could be worse off investing in shares over a 5 year period unless of course there was another Black Swan event such as the Coronavirus pandemic. The dividend income alone will more than cover the interest cost.

Estimating potential investment returns against low-cost mortgage interest rates is one thing but what about the effect of inflation on your debt? You see, if you were to take out a 5 year fixed rate mortgage over 5 years and RPI inflation averaged say 5% a year then the real value (inflation-adjusted) of your mortgage would decrease by 27.62% even if you had repaid none of the capital. A compelling reason if ever there was one to borrow when inflation is high. You repay your debt with depreciated money.

So when you think about it your investment would have to fall by more than 27.62% over a 5 year period for you to be worse off in real terms (inflation-adjusted) which is unlikely to happen especially since we only had a market crash less than 2 years ago when Coronavirus became a pandemic.

Of course, in 5 years’ time the situation could be completely different if for example inflation were then under control and interest rates were a few percentage points higher. Arguably that may then represent a better time to repay debt. Only time will tell. You know it makes sense.*

*The value of your investments can fall as well as rise and are not guaranteed. Past performance is not a guide to future performance.

The contents of this blog are for information purposes only and do not constitute individual advice. You should always seek professional advice from a specialist. All information is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of relief from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. This blog is based on my own observations and opinions.

The information in this blog is a guide only and should not be relied on as a recommendation or advice that any particular mortgage is suitable for you. All mortgages are subject to the applicant(s) meeting the eligibility criteria of lenders. Your home may be repossessed if you do not keep up repayments on your mortgage.

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