Interest Rates Skyrocketing: Time to Rethink Your Mortgage Strategy?

With sky high interest rates do you need to ditch your emergency fund into your mortgage and stop contributing to your pension?

My mortgage / student loan is over 5% interest! What do I do?

Inflation hit, interest rate rises followed and now people are paying 6%, 7% or more on their student loans and mortgages. Should we change strategy and pay this off quickly?

Rebel Finance School 2024

Last year on Rebel Finance School we were going through our content as always, but something changed. The course participants started commenting in the chat and it stopped us dead. This is one of the reasons I LOVE Rebel Finance School as there is ALWAYS something for us to learn, something always changes.

We teach the simple steps to wealth:

  1. Get an emergency fund of £1000 (whatever that is in your currency)
  2. Pay off expensive debt (greater than 5% interest)
  3. Increase emergency fund to 3-6 months of expenses
  4. Start to invest and buy assets

Our advice on debt was simple, expensive debt was anything over 5%. However what changed last year was that rising inflation, sky rocketing interest and the aftermath of meant a huge number of people were finding that their student loans and mortgages were suddenly becoming expensive debt under our definition.

We were inundated with messages. Does this mean we should stop investing and pay down our mortgage?

Do I need to take my 3-6 month emergency fund and pay off the mortgage / student loan and then go back to rebuilding it after I am mortgage free? This could take decades!

High interest rates seems to have changed everything! Or did it?

Classification of expensive debt

We classified expensive debt as anything over 5% for one simple reason. We felt that if the stock market returned 10%+ and wasn’t guaranteed then you might as well pay down debt quickly over 5%.

Whilst interest rates were low, which they had been ever since the financial crisis of 2008, this made a lot of sense. As interest rates sky rocketed after covid it meant that mortgages and student loans suddenly got categorised as expensive debt as well.

So we now have 3 options

  1. The Donegans reclassify what expensive debt is
  2. We come up with a strategy for dealing with times when interest rates goes up
  3. Or we stick blindly to the original plan, follow the steps rigorously and keep going

As you probably know we are huge fans of maths over emotion when it comes to your finances so the first step is to understand the math.

Simple interest rate maths

Simple interest rate maths.

The higher the interest rate on your loans the faster it compounds against you. What this means is that if you owed money at different interest rates you would pay different amounts of interest that get exponentially bigger as the rate goes up. Let’s look at some examples

Let’s imagine you have a £10,000 loan over 10 years. Here is what you would repay depending on different interest rates.

  • At 1% interest, you would pay back a total of £11,046
  • At 2% interest, you would pay back a total of £12,190
  • At 4% interest, you would pay back a total of £14,802
  • At 8% interest, you would pay back a total of £21,589
  • At 16% interest, you would pay back a total of £44,114
  • At 24% interest, you would pay back a total of £150,518
  • At 50% interest, you would pay back a total of £576,650

At 1% interest you pay £1,046 interest. Not too much. If you add an extra percentage point you pay £2,190 which is a little over double.

You might be thinking why is the interest I pay back over double when I only doubled the interest rate. That is compounding.

The higher the interest rate the faster your debt compounds against you. If your interest rate is 8% you will end up paying back £11,589 in interest which is more than you borrowed! And that is only 8%. Do you know what the interest rate is on credit cards?

Katie got super excited and wondered if we could visualise this on a chart! She did.

The blue line shows what our brain thinks happens to the interest way pay if it just doubled in a linear fashion with the doubling of interest rates.

The orange bars show what really happens as the interest exponentially compounds against us crippling us with more and more repayments.

You would think that is the interest rate doubles from 16% to 32% then you would double your repayments. In reality you end up paying 5 times the amount of interest.

Is 50% interest even possible?

On RFS a couple of years ago we were doing the debt case study and the people we worked with had an overdraft balance. This balance was at 50% interest. Katie and I were both shocked, we felt like this was criminal and surely should be illegal!

Over 10 years they would have gone from a £10k debt to paying back £576,650. Yes you read that right they would have had to pay back over half a million pounds on that debt. They were NEVER GOING TO PAY IT OFF.

This is the exponential nature of debt and something we have to be hugely careful with. 1% point as we show with fees can be worth hundreds of thousands over the decades.

The higher your interest rates goes the more sense it makes to pay it back quickly.

What could you earn in the stock market?

Since inception the fund that Katie and I have invested in, the Vanguard FTSE Developed World Ex UK has returned an average of 13.6% a year. Pretty amazing right.

So if you choose to pay off you 4% mortgage instead of investing that extra money you would have got from investing vanishes. You are making yourself MASSIVELY poorer by paying off the mortgage when compared to investing in the stock market. Read the article should I pay off my mortgage or invest here.

People are then saying “Does that mean if my interest rate is less than the stock market returns then I should pay off the debt slowly and invest instead?”

Probably not as those gains are not guaranteed. There might be a few bad years and you might get 7% average. This is the risk. Do you take a guaranteed “return” of 7% paying off the debt or a possible 10% plus in the market that is guaranteed?

The steps to getting wealthy

Let’s step back and look at the steps to getting wealthy and how all this chat of interest rates, inflation and exponential debt affects them.

  1. Get an emergency fund of £1000 (whatever that is in your currency)
  2. Pay of expensive debt (greater than 5% interest)
  3. Increase emergency fund to 3-6 months of expensive
  4. Start to invest and buy assets

The reason for the first step is that if you have an emergency then this small fund will protect you from having to go further into debt.

The second step was designed to help you know which debts to get rid of first and have a clear plan to get out of debt. This step is really the foundation of the debt attack strategy. The questions from our audience came from the fact that under our definition of high interest rates debt, their mortgages were reclassified.

The questions we get asked are:

  • If my mortgage / student loan rate is over 5% do I put all my emergency fund against it and go back to step 2?
  • Are you saying that if my mortgage rate is over 5% I have to pay off the whole darn thing before investing? This will take decades!
  • Are you saying I should stop my pension contributions at work and redirect them towards my mortgage?

Things to think about:

  1. Interest rate: a 1% difference can make a HUGE difference as you have seen above. If it was me and my mortgage had gone to 6% knowing what I know now I would have still invested first and not reclassified it as expensive debt. If it had gone to 7% I would probably be paying down that mortgage as quickly as possible first
  2. Employer matched contributions for pensions: I would not be stopping employer matched contributions for my pension to pay down debt unless my interest rate was ridiculously high. This is because you are putting in say 5% of your pay, the employer matches that 5% basically giving you an instant 100% return and then it grows in the market afterwards. This is FREE money and amazing growth. I would be taking the free money even if my interest rate was 10%.
  3. It’s not binary: Katie’s favourite expression. If your mortgage was say 6% and you had a decent gap then maybe you could put half the gap to investments and half to paying down the mortgage. It is never binary and you have many options available to you.
  4. What does the future hold? This is where we get out our crystal ball and make some stuff up! This is not going to be accurate. And actually Katie and I repeated to ourselves that mortgage rates can only go up for the 10 years we had a mortgage and they NEVER did! We locked into an interest rate to our detriment! So no one knows. We could debate this forever and one of us will be right. I am eternally optimistic!

To directly answer your questions:

  • If my mortgage / student loan rate is over 5% do I put all my emergency fund against it and go back to step 2?
    It depends on the interest rate. It is was 6% I would not. I probably wouldn’t change my plan very much. If it was 10% interest rate I would probably throw everything I have got at it.
  • Are you saying that if my mortgage rate is over 5% I have to pay off the whole darn thing before investing? This will take decades!
    We come back to interest rates and how far north of 5% we are. If it was 6% I would probably not change my strategy. If my interest rate was 10% I would absolutely be paying it down till interest rates go back down again. Remember things change and high interest rates won’t last forever.
  • Are you saying I should stop my pension contributions at work and redirect them towards my mortgage?
    I don’t think so. Matched contributions are MAGIC and I would still be putting my cash in to get the free match and building my pension. This is still tax efficient.

The better you understand interest rates, inflation and the maths behind all of this the clearer you will see the situation. Maths and numbers bring clarity and remove the fog of overwhelm and panic.

Take control of your fears through maths and understanding the numbers at a deeper level.

I would LOVE LOVE LOVE to know your thoughts and questions. Stick them below and we will further develop this article to help us all.

Thanks for reading and here is to a bright financial future for all of us

Love Katie and Alan

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