Six Degrees of Leverage: Part III
This is the third in a series. The first look at how leverage can change a rate of return on a bond and the dramatically increasing M2 money supply.
The second looked at the leverage of how mortgage terms dramatically change with changing the rate and the amount of income that can be used on debt.
When I look back to the 70s and mother’s second mortgage, well, to qualify for a second mortgage the money you had to qualify under conditions of paying the debt back was a shorter term – a 10-year time frame. And what have the Snake Oil Financial Wizards of the 21st century done? They’ve issued second mortgages that span 30 years and have the first five years as interest only payments. Lending standards of the 70s allowed up to an additional 8% of income to be going towards this shorter-term debt, which included car loans and student loans. The table shows how much second mortgage a $100k income could support with a 10-year repayment plan and the insane 30-year repayment plan.
| 30 Year Mort |
| 2% || 72,000 || 180,000 |
| 3% || 69,000 || 158,000 |
| 4% || 66,000 || 140,000 |
| 5% || 63,000 || 124,000 |
| 6% || 60,000 || 111,000 |
| 7% || 57,000 || 100,000 |
| 8% || 55,000 || 91,000 |
| 9% || 52,000 || 83,000 |
| 10% || 50,000 || 76,000 |
| 11% || 48,000 || 70,000 |
| 12% || 47,000 || 65,000 |
It is interesting to note the total level of mortgage debt a $100k household income could carry with prudent lending standards. You have $243k first mortgage and at the same12% an additional $47k, for a total of $290k. Affordable housing is defined as being 3 or less for median home price over median income. If you look what prudent lending standards of the past allowed, well, they would only allowed you to buy a home you could afford with prudent lending standards. And make no mistake here; household budgets are tight when paying the maximum allowed.
By increasing the length of repayment on the second mortgage the borrower ends up with $160k more in debt servicing costs, $8k x 10 = $80k versus $8k x 30 = $240k. It is a disaster in terms of people’s ability to get ahead of the debt. With 30-year second mortgages there is no 10-years of hardship and then life gets easier. They won’t be freeing up cash flow for when their car needs replacing with their 30-year second mortgage. Forget about saving for retirement or their children’s education.
If you want true economic strength from low interest rates you set a prudent standard and then if rates are lower, well the family spends a smaller percent of their income on debt servicing. The family then has options to save for retirement, pay down debt faster, and to spend money in the economy on other goods and services.
Part lV coming...