Thursday, April 19, 2012

Risks of not making early mortgage repayments

In response to yesterday's post on when to make early mortgage repayments I received a comment pointing out the risks associated with carrying mortgages into retirement. The comment was quite on point in that stating that I was focused on the rewards and that carrying debt into retirement involved a greater degree of risk than not carrying debt. The same is true of debt at any time, but I will keep the discussion focused on the issues as they apply post retirement - that is when I no longer have employment related income to fall back on and have to meet the repayment obligations from my investments.

Interest rate risk

As is usual in Hong Kong, the interest rates on my mortgages are floating rates. All my mortgages are set at a margin over either one month or three month HIBOR. If HIBOR rises then the interest rates I pay on my mortgages also rises. If interest rates rise far enough and stay elevated for long enough, the investment properties will eventually end up with negative cash flow.

Rental income risk

The inward cash flow from the properties depends on three things: (i) the properties being occupied (ii) the amount of rent which each property earns and (iii) the tenants actually paying the rent. In adverse economic conditions the amount of rent each property can earn could decline and the vacancy factor could increase. This was certainly the experience in 2001-2003 when many landlords were forced to cut rents or accept lengthy vacancies.

Cash flow risk

The risk of a combination of rising interest rates, increased vacancies and lower rents pushing the properties into a negative cash flow situation is a very real risk. It's also worth remembering that if/when such circumstances occur, property prices will probably fall, so I have to assume that selling a property to alleviate the problem is likely to be a very unattractive option.

Inflation risk

Inflation has been higher than interest rates for several years now. As long as that situation is continues, keeping the mortgages on the properties actually reduces the risk of inflation adversely affecting my retirement plans.....right up to the point where higher inflation results in interest rates high enough to cause negative cash flow from the properties.

How big is the risk?

It has been some years since I last did a sensitivity analysis on the portfolio and I will do one at some stage before I retire. However, off the back of the envelope, I can say that the properties will still be cash flow positive:
  • if any one property is permanently vacant (or the two smallest ones); or
  • if vacancy rates remain the same as they have for the last few years but rents are cut by around 12%; or
  • if interest rates increase to a bit over 5%.
Of course, as explained above there is a possibility of all of these things happening at once which will result in negative cash flows much sooner.

It's also worth remembering that because the mortgages are P+I, the sensitivity to rising interest rates gets reduced each month, eventually being eliminated altogether once the last mortgage is fully paid off. One mortgage will be completely paid off in mid 2013 and the last one in 2029. The biggest mortgage is the one on our home and that will be paid of in 2020. As each mortgage is paid off the debt related risk declines.

I also intend to carry a meaningful amount of cash or near cash in retirement. If necessary, this can be used to either cover a negative cash flow or make some early repayments - the amounts involved are enough to be meaningful.

There is considerable room to cut our expenses if the need arises.

I could always get a job if the need arises (as could Mrs Traineeinvestor for that matter).

In short, while the risk is quite real, it is not one that I worry about too much. It is also one that will disappear over time.

Short term risk v long term risk

The alternative to carrying mortgage debt into retirement is to pay down the debt in lieu of making other investments and/or selling assets to reduce debt. While such actions would reduce the short term financial risks, over the medium to longer term the end result would be a smaller pool of assets and a retirement that is more vulnerable to adverse events (in particular inflation).

By not making earlier repayments, I am electing to increase the near term risks in order to reduce  the longer term risks to the financial sustainability of my retirement. Given that it is easier to find well paying employment in my late forties and fifties than in my sixties or seventies, that is a trade off that I am more than willing to embrace.

I will do the sensitivity analysis but for now at least I am quite comfortable with my decision.


Anonymous said...

Very interesting - thanks for this.

Personally I think your stress test conditions are a little weak. In 1996 I rented a flat in DB for 12,000. A few months later similar flats were going for 14,000 but that was the peak. At the low several years later, there were many vacancies in the block and some were rented for around 5,000.

That's a lot more than a 12 percent drop...

traineeinvestor said...


Thanks for the comment.

The numbers given are the rough guesses for where I would cross into negative cash flow territory if the market turned down today. The situation improves as each mortgage is paid off. Mid 2013 is the when the first one goes and it makes quite a bit of difference to the cash flow having at least one property with no mortgage at all. Also each month that goes buy sees the total principal balance reduce - even if there is no effect on cash flow until a mortgage is paid off, the amount needed to discharge the mortgage falls.

You are of course correct about how far the market could drop - if I had to halve my rents at a time when interest rates were soaring, cash would be walking out the door pretty rapidly a that point and I would be making early repayments as quickly as possible.


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