Twenty-one

if I get two cards, pay no attention to them and keep twisting then eventually I will go bust.

Some of us might be familiar with the card game twenty-one. I am sure the rules are somewhat more complex than the ones we use when playing as a family. We have matchsticks and play until someone wins all the matchsticks. As an extra twist to the game the ‘winner’ then has to put all their winnings in the middle and we play to be crowned the overall winner.

Recently I read a tweet which asked the question; ‘interest rates will rise, are you prepared?’

The tweet made me think back to twenty-one. Fundamentally the game is about whether you stick or twist (gamble). When you consider the question are you prepared for interest rates to rise it is not dissimilar to twenty-one – are you prepared to stick or twist?

Stick or twist?

It sounds like teaching granny to suck eggs but budgeting (knowing what we have coming in and going out) is the only way to manage our finances. If we have no control on our budget then eventually we will go bust.

Twenty-one is the same; if I get two cards, pay no attention to them and keep twisting then eventually I will go bust.

To play the game I have to look at my cards and decide what to do next. Sometimes the risk is greater and I have to decide whether to gamble or not. If I fail I am bust. If I don’t I might win.

Budgeting is to some extent the same but crucially it should remove the uncertainty (gambling) aspect because the aim is to make sure the money coming in and going out balances.

However, a budget is a moving beast. Costs can go up or down so it constantly needs to be reviewed. One of the biggest strains on household budgets is the mortgage (for those who own a house), making up 34% of the monthly outgoings according to the Telegraph. It is feared when interest rates rise this could edge above 40%.

In the past it has been much harder to predict the direction of interest rates but this time it is somewhat different.

The interest rate dilemma

For over 5 years interest rates have been at a record low. There is one certainty and that is that interest rates will rise at some point; it could be in 2016 or 2017 but they will go up. The hint from the Bank of England is that it will be in 2016 and that by the end of the year rates will be 1%, which seems low compared to the past. It is also expected that rates will rise to a more normalised level of 2 to 3% within five years (although this is not guaranteed).

Going back to twenty-one if you have 21 in your hand you will stick. If you have lower than this, then in theory you might twist and I think the same theory can be applied to mortgage rates.

Some people will not have fixed their mortgage deals because while rates have been low it has not necessarily been a sensible move, but we are now at a point where a decision needs to be made.

If someone has a tracker mortgage of 1.89% plus base rate of 0.5%, then currently they are paying 2.39%. If they can fix their mortgage at 2.39% for five or ten years, at that level then they might consider that a good option. The reason is simple, if rates go up 0.5% in 2016 they will move to 2.89%.

The risk is that banks may offer lower fixed rate mortgages in the coming months but this is the gamble people have to take, alternatively this could be as low as they get.

Another option is to fix for 2 to 3 years and some of these rates are below 2%. The gamble with these is that although it might reduce costs in the short term, coming out of the fixed rate in two to three years may see a hike in costs.

The costs

According to the Telegraph in June 2015 the average mortgage is now just over £160,000.

A repayment mortgage over 20 years will cost £840 per month at 2.39% (tracker of 1.89% plus base on a £160,000 mortgage). If rates go up by 0.5% in 2016 this will increase to £879 per month. Assuming they go up to 3% it increases to £1,046 per month (Source moneysavingexpect.com).

In total that is an increase in cost of 25% over a potential five year period.

The flipside

Some may argue that fixing the mortgage is delaying the inevitable. If you fix your rate at 2.39% for five years, then in five years’ time your mortgage costs will jump to whatever is on offer at the end of the period.

At least a gradual hike is better than a sudden hike. This is the flipside; do you stick or do you twist? That depends on your budget.

Take an example: you fix your £160,000 mortgage for five years at 2.39% paying £840 per month (assuming a 20 year term). At the end of 5 years your mortgage is £126,864, and you have 15 years remaining. If rates are at 3% and you can get a mortgage for 4.89% then the monthly payment will be £996 per month (an increase of 18.5%).

So the increase in the end might not be so bad, and your financial position might have improved. So increases will be relatively affordable.

Conclusion

This is the twenty-one moment and people can no longer keep their heads in the sand. For those on variable or tracker rates do they do nothing knowing rates will go up? (and so costs will go up) or do they stick either at the level they are on at the moment or lower?

There is no simple answer to this and there are many variables but the argument is very strong towards sticking, if we can’t at the moment face increases in our payments. But we must accept that at the end of the term our costs will go up so this should be factored in.

NOTE: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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