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Why Interest isn’t always simple - news article image

Why Interest isn’t always simple

17 Jun 2022

5 minute read

Before you think we’re about to go into a discussion of the differences between simple and compound interest, this isn’t that sort of an article. Instead we’re going to take a look at how interest rates impact on a variety of aspects of financial planning and why how something is named doesn’t necessarily reflect what something is. 

This morning I saw the news that interest on student loans is to rise from 4.5% to 7.3% rather than the predicted 12% along with a comment from the NUS that this rate was still cruelly high. However, not only will the rate increase make no difference to what a student repays each month, it will also have no effect at all on the majority of students. 

Student loans are not loans in the traditional way we might think of them, but more a method of keeping track of how much extra tax a student might end up paying when they start work. Repayments are based on your income, not the loan or interest rate, and deducted like any other tax; there is a term after which anything left gets written off; there is no debt to declare to a mortgage lender for example. Figures show that 75% of students never repay the full loan amount before reaching the end of the term and so for them, what the interest rate might notionally be is totally irrelevant. 

This makes planning for parents and grandparents particularly difficult. If you don’t take the maintenance loan for example and instead pay all the costs, then if your son or daughter decides to become a vicar, you will likely find that you have paid unnecessarily. Even Bishops are paid under £50,000pa and you would need to be a real high flyer to even pay back the original loan amount.

Meanwhile, when people take about rising interest rates, in the main they are talking about the Bank of England Base Rate and the knock on effect this might have on savings rates and lending rates. Here things are simpler as a rise in Base Rate would be reflected in a rise both in the rate you are paid on your savings and the rate you are charged on your mortgage or other debt. Of course, the suspicion is that the increase you are offered on your savings is never as much as the Base Rate rise while the interest you are charged on your mortgage may be more. 

Less simple though is what happen to Fixed Interest Investments when interest rates rise. To be clear, this is not a fixed term deposit account such as you might get from Nationwide or Aldermore; these are a group of investments termed Fixed Interest Investments and are investments in debt issued by Governments (Gilts in the UK), Local Authorities and Companies (Corporate Bonds). Used within an investment portfolio alongside equities in order to diversify the risk and in theory safer and less volatile, they are normally held by way of a Fund, which invests into a whole range of different individual Fixed Interest Investments.

Although each Gilt or Bond is issued for a term, with a stated rate of interest and paid back in full at the end of that term, during the term they can be sold and bought and the value of each is determined mainly (Gilts) or partly (Corporate Bonds) by what is happening with general interest rates. 

As an example, the UK Government issued War Loans at 5% interest and 3.5% interest in order to finance the First and Second World Wars. Unable to be redeemed by the investor, these languished for years, an interesting piece of paper in times when interest rates were in double figures. As interest rates fell, from 5% in 2008 to 0.5% in 2009, suddenly these War Loans looked valuable. When banks were paying you next to nothing on your money, a guarantee of 3.25% from the Government each year looked pretty good. However in order to get someone to sell you that guaranteed income you would need to pay them more than the face value. The lower the prevailing interest rate, the longer the fixed interest investment had to run, the more expensive the fixed interest investment would be to buy. 

Since December last year we have seen Base Rate increase from 0.25% to 1%. That has been reflected in falls in the value of fixed interest investments, with the FTSE Actuaries Conventional Gilts All Stocks index down 14.55% since December 1st and the ICE BofA Sterling Non Gilts index (a useful Corporate Bond index) down 11.06% over the same period. What this means is that whilst equity markets have been bouncing around as a result of war in the Ukraine, with some very sharp drops at times, Fixed Interest Investments have been falling in value rather than providing the positive news that they did in 2020 when Covid hit. 

Does this mean that Gilts and Corporate Bonds have had their day? No, in the same way that when shares plummeted two years ago it didn’t mean that they had had their day as something useful for medium to long term investment. As interest rates rise, the individual Gilts or Bonds that a fund buys to replace the ones that mature will be replaced with higher rates of interest. Which means that the impact of rate rises will lessen and peter out over time and the returns from the higher paying investments will come through over the longer term. 

What it does mean is that the phrase Fixed Interest may not mean what you think it means and it is important to understand what is in your portfolio and to never be afraid to ask questions; it’s a bit of a cliché but there are no silly questions when it comes to understanding where your money is invested and there shouldn’t be any silly answers. 

PS : guess what – the Government redeemed the War Loan in 2015 and has saved a packet on interest payments since

Why Interest isn’t always simple - news article image


Ed Gibson

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