Inflation - deflation and debt
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.
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