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Inflation - deflation and debt

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March 28, 2008 – Comments (11)

CR has high lighted a good piece about the effects of inflation and deflation on debt

A "truth" that I was told as a child, teen and even young adult was that managing a mortgage was only hard the first few years because wages went up relative to the debt.  Well, wages have been flat.  I'm sure that household costs have at least doubled, and in some cases, like gas, tripled.  Last week in the grocery store I saw strawberries for $10.  I think of that size of strawberries as being expensive at $5 and in season they can be as low as 99c.

So, we have this idiot standard of a percentage of income allowable for debt borrowing irrespective of the interest rate and contrary to popular belief, low interest debt is far more burdensome.

I'm sure some are thinking, what do I mean loan interest debt is more burdensome?  If you own $100k at 5% it is way less burdensome than 100k at 10%.  Absolutely true, yet because of the idiot standard of a percentage of income allowable for debt borrowing we don't end up with sensible limits on borrowing related to the fact that low interest debt is more burdensome.

So, you end up with 30% of income servicing debt at 5% or 10%, and this is where the extreme burden of low interest debt raises it ugly head.  I'm reproducing part of my "Six Degrees Of Leverage" post here to show the difference in burden when you try and pay that debt back.  Say you have household income of $100k.  The table shows the ratio of principal to interest for the $900k of payments over the 30 year period.

                                                             
Rate Principal
Interest
2% 676,000 224,000
3% 592,000 308,000
4% 524,000 376,000
5% 465,000 435,000
6% 416,000 484,000
7% 375,000 525,000
8% 340,000 560,000
9% 310,000 590,000
10% 285,000 615,000
11% 262,000 638,000
12% 243,000 657,000

What is important to consider, principal is expected to be paid back 100%. Interest, however, can be modified through increased payments.

Look at the 12% row. At 12% only 27% of the $900k paid over the 30 years is principal. The rest is interest. The greater the proportion of the repayment schedule being interest the better. Consumers usually have a clause that allows them to prepay a certain amount of the mortgage and that gives an enormous ability to reduce the repayment burden by reducing the amount of interest they pay.

This next table calculates the savings from increasing payments by 10% and 20%, which is in the realm of realistic.

          
Rate
no increase
10% increase
savings
20% savings
12% 360 months
216 months
306,000 167 months
399,000
7% 360 months
272 months
152,000 224 months
228,000
2% 360 months
316 months
31,000 282 months
54,000

Low interest debt simply leaves people with few options to reduce their burden, and I'm not seeing a single economist out there talking about this, and imho, it is beyond enormous in terms of how it will stiffle people for life.  If this concept was truly understood out there you'd have economists, consumer advocacy groups, etc., screaming for regulation on how much of income can be used to qualify for debt on a sliding scale relative to the interest rate instead of this ba$tardization of math concept crap currently being use.  So, at 12% that 30% of income standard is fine, but at 6% people ought to have been limited to perhaps 24% of income. 

How to set the standard ought to be looked at more closely, and I just picked 24% because it is easy, just subtract (12 - interest rate) from qualifying percent income.  

At 12% the table show you can borrow $243k.  With 24% of income at 6% you would be limited to $333k, a full $83k less than what the current policy allows, but it is also $90k more than what the 12% allowed.  I personally think this is still a somewhat too loose of a standard.  

I actually didn't get around to commenting on what I intended.  But, now that I've thought about it more, the problem is what I've just written about, and if you set responsible and reasonable lending standards that are based on how math works rather than the nonsense we currently have, the entire crap Mishkin is talking about is a mute point.  People's emotion can't get them into the kind of trouble they've gotten into and there is room for the economy to adjust to the business cycle regardless of if there is some inflation or deflation. 

11 Comments – Post Your Own

#1) On March 28, 2008 at 9:40 AM, dwot (45.58) wrote:

 Of course, with down right inside endorsed fraud...

http://www.oregonlive.com/business/oregonian/index.ssf?/base/business/120658650589950.xml&coll=7

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#2) On March 28, 2008 at 9:45 AM, dwot (45.58) wrote:

I'm just reading the above link a little more, and wtf...

"During the boom, it was common for lenders and brokers to get paid more for risky subprime loans than for 30-year fixed-rate loans because the higher-interest loans fetched a higher price on Wall Street."

Why, pray tell, am I not reading about Americans protesting the Wall Street bailouts?  Why aren't the people organizing to protest against tax payers paying for this while these wall street players have an average income of something like $300k I believe I was reading this week... 

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#3) On March 28, 2008 at 10:35 AM, StKitt (29.70) wrote:

Why no protests? Probably because most people in America are now well-fed sheep who can't be bothered to wrap a problem like this around their tiny sheep minds. They prefer to wait for the slaughter... and then say it's God's will.

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#4) On March 28, 2008 at 11:20 AM, madcowmonkey (< 20) wrote:

Baaaah. Baaaaaaaaaaaah. 

And heeere comes the class warfare? 

Here is one protest that made the news. There are too many strong opinions (people that are pissed) on this subject to post more.

Baaaaaaaaaaaahhhhhhhhhhhh. 

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#5) On March 28, 2008 at 11:48 AM, anchak (99.86) wrote:

You are talking about Yield Spread Premium....the mechanism by which the broker gets a higher commission based on the Yield ie Interest Rate on the account.........I have seen some interesting discussions online ( very heated ones too....especially from the broker community) about this.....and I believe Bush even mentioned it in one of the mortgage reform piece.

On the face of it , it definitely has a clear conflict of interest written all over it.

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#6) On March 28, 2008 at 12:01 PM, FleaBagger (28.07) wrote:

Usually when you're borrowing money, the principal borrowed, not the total amount paid to the lender, is the constant. So your "higher interest is less burdensome" assertion is absolute nonsense.

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#7) On March 28, 2008 at 12:09 PM, devoish (96.39) wrote:

Deb,

Your post showing that borrowing in a high interest rate environment with a low principle is preferable because of the opportunity to prepay interest, or refinance at potentially lower rates will be shared with my kids. As long as prepaying is a possibility. Some loans do not allow it or invoke penaltys for prepayment. Hopefully I can get them to save enough to just pay cash though.

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#8) On March 28, 2008 at 3:27 PM, leohaas (31.02) wrote:

So, this whole blog was to show that it make a lot of sense to pre-pay a mortgage when your rate is 12%, but not when your rate is 2%?

Duh...

I gladly refinance my current 15-year mortgage to a 30-year 2% mortgage! No questions asked... 

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#9) On March 28, 2008 at 3:33 PM, charlesblazer (51.97) wrote:

Flea, I believe that one of dwot's points is that the principal borrowed is not, in fact, a constant.  As rates drop, banks allow people to borrow more.  As people are allowed to borrow more, the price of property goes up to take advantage of it.  The only constant is the buyer's income.

dwot please correct me if I'm wrong.

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#10) On March 28, 2008 at 7:24 PM, dwot (45.58) wrote:

Exactly Charles, short term allowing people who have already established themselves to refiance at lower rates helps the economy.  They have more disposible income for other things.  This is the short term view that Greenspit had.  But, by not looking at the burden of low interest debt if you borrow to the limit and adjusting the lending standards of % income allowed based on the rate of interest you have a grossly instable financial system.  The short term financing of long term loans is proving to be a disaster.

Leohaas, no, it was to show that you have little hope of reducing the debt burden by paying more at lower rates.  People taking low interest loans and investing at higher rates elsewhere is a big problem.  It creates massive instability and gross over investment.

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#11) On March 31, 2008 at 8:50 PM, FleaBagger (28.07) wrote:

Sorry I misunderstood you, dwot. I did not know you were comparing different possibilities the fed could be shooting for in attempting to affect the entire economy. I was thinking of it from a personal finance perspective, from which, yes, the principal borrowed is constant, unless you're an idiot.

Unfortunately, we do have a lot of idiots who believe things like "Stretch to buy as much house as you can" and "You too can make a full-time income flipping houses part-time!" That is why we had inflated prices. Perhaps they would not have been such suckers if interest rates had been higher, but they should have taken responsibility for their own actions. They don't deserve a bailout, the banks that lent to them without due diligence don't deserve a bailout, and the rest of us desrve better than to have the value of our money taken away to help out people who have no just claim on it.

We wouldn't have inflation and a "free money" system if we didn't have government borrowing and printing money on a whim so they can rush in and rescue everyone from everything.

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