FOOL'S EYE VIEW
The Myth Of Cheap Debt

By Stuart Watson (TMFTiger)
November 7, 2002

Debt today is cheap, or so we're told. Interest rates are the lowest they've been for 40-odd years even though the Bank of England decided not to cut UK rates today.

The trouble is debt isn't really that cheap at all, not once you consider the low level of inflation we have at the moment and expect to see for the next few years. Rates of interest that appear low are luring many of us into taking on correspondingly higher levels of debt that may come back to haunt us further down the line. In the past, high levels of inflation have steadily reduced our the real value of our debts. A mortgage that was a little tight in the first year or two soon became comfortably manageable and almost unnoticeable in its final few years.

It's easier to see with an example. Low interest rates are often cited by those entwined within the housing industry as making larger mortgages more affordable. At first, of course, this is true. We can take a much larger mortgage than we could have done several years ago and yet still pay the same amount in interest. Let's say we have a £60,000 mortgage charging 8% interest and another £100,000 mortgage charging 4.8% interest.

• Example 1 - £60,000 x 8% = £4,800 per annum or £400 per month
  
• Example 2 - £100,000 x 4.8% = £4,800 per annum or £400 per month

So low interest rates allow you to get a lot more mortgage for the same monthly outlay. That's all straightforward enough. Let's assume we're earning £2,000 a month so that, in both examples, the interest payments account for 20% of our salary in the first year. Let's also assume that this is an interest-only mortgage, meaning that we're paying into a separate investment fund in order to cover the capital repayment of the mortgage.

What's the story 10 years down the line? To keep things simple, we'll assume that interest rates have remained the same. In the first example our earnings, boosted by higher inflation, have grown at 8% a year. Very nice. That means we're now earning around £4,300 a month, so the monthly interest charge now accounts for just 9% of our salary.

In the second example our earnings have only grown by 4.8% a year, meaning we now have an income of £3,200. Not bad. The interest payment has fallen, as a percentage of our salary, but not by as much. It still represents 12.5% of our salary.

As the years go by, the gap between the two examples widens further. In fact, after 25 years, in the first example the monthly interest payment has shrunk to less than 3% of our monthly salary, whilst in the second it's still lurking around the 7% level.

Naturally this is a simplistic example. We also have to pay off the original amount of the loan as well. In the first example, not only it is lower to start with, but also inflation reduces it far more quickly.

Perhaps what is more important is the effect that any change in interest rates might have. And in this case, by change, we mean primarily the risk of rates going up. If rates go up by 2% in the first example, then we'll need to find an extra £100 a month. In the second example, because we borrowed a larger amount, we're looking an additional £167 a month.

So, even though the two debts looked equally manageable to begin with, as the years go by, the first debt turns out to be considerably cheaper. In other words 'cheap' debt really isn't as cheap as many people like to think.

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