Six Degrees of Leverage: Part V
The first 4 parts can be found here.
The table below shows how declining rates and increasing second mortgage terms reduces household leverage to control debt, and this alone increase risk substantially. In all cases payments for the first mortgage is $30k per year for 30 years and totals $900k with no adjustments to the payment schedule. For a second mortgage $8k for 10 years is $80k and for 30 years is $240k.
| Rate ||Principal ||Interest || 10 Yr Prin || 10 Yr Int || 30 Yr Prin || 30 Yr Int |
|2% ||676,000 ||224,000 || 72,000 || 8,000 || 180,000 || 60,000 |
|3% ||592,000 ||308,000 || 69,000 || 11,000 || 158,000 || 82,000 |
|4% || 524,000 ||376,000 || 66,000 ||14,000 || 140,000 || 100,000 |
|5% || 465,000 ||435,000 || 63,000 ||17,000 || 124,000 || 116,000 |
|6% || 416,000 ||484,000 || 60,000 ||20,000 || 111,000 || 129,000 |
|7% || 375,000 ||525,000 ||57,000 ||23,000 || 100,000 || 140,000 |
|8% || 340,000 ||560,000 || 55,000 ||25,000 || 91,000 || 149,000 |
|9% || 310,000 ||590,000 || 52,000 ||28,000 || 83,000 || 157,000 |
| 10% || 285,000 ||615,000 || 50,000 ||30,000 || 76,000 || 164,000 |
| 11% || 262,000 ||638,000 || 48,000 ||32,000 || 70,000 || 170,000 |
| 12% || 243,000 ||657,000 || 47,000 ||33,000 || 65,000 || 175,000 |
First, by increasing the second mortgage from a 10-year term to a 30-year term total payments increase by $160k. So this one change makes the total payment stream change from $980k to $1,140k, or a 19% total increase.
Look at the 12% row. At 12% only 27% of the $900k paid over the 30 years is principal. The rest is interest. The great 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.
The principal has to be repaid in full, however, because 73% of the repayment burden is interest, there is enormous opportunity to reduce the repayment burden by taking advantage of clauses allowing increased payments.
Say the household increases their monthly payment from 30% of income to 33% of income. A mere 10% increase in mortgage payment changes the repayment of the mortgage from 360 months to 216 months. The total payment stream for the first mortgage changes from $900k to $594k, or total savings of $306k to the homeowner. A highly manageable payment change has reduced the debt burden by more than 1/3rd. An increase to 36% of household income reduces the term to 167 months and $501k, for a total savings of $399k. Notice that the second extra 3% of gross income did little compared to the first extra 3%. So, when homes were priced affordably at 12% interest there was an enormous ability to redistribute the household cash flow to reap enormous benefit, and when I worked in banking in the early 80s this was the behaviour I witnessed. Indeed, there is high motivation to reduce debt and I saw people regularly paying off their mortgages while still in their 30s.
Contrast the example to a home being bid up to 30% of household income at 7%, a rate that many home owners have today, the stuff of the so-called rate freezes in the media today. In this example 42% of the payment stream is principal. $375k is 54% higher than $243k and even though the payment is the same, the homeowner’s leverage to get ahead has been grossly marginalized. Increasing payments by the same amount, to 33% of household income, reduces the number of months to 272 and the total payment stream to $748k, a savings of $152k, which is less than half of the savings the same increase in payment gave before. A 20% increase in payment, or going to 36% of gross income reduces payments to 224 months, or $672k or total savings of $228k. In order to save the same $306k in interest as the homeowner who qualified at 12%, the 7% qualifier would have to increase payments to 41.5% of their household income, a highly unlikely feat to manage.
The last 4 columns of the table are principal and interest amounts for 10 and 30-year mortgages. With a 2% teaser second mortgage over 30 years versus 10 years the extra principal the homeowner gets saddled with is $108k. At 2% there is practically no opportunity to reduce the repayment burden by increasing payments.
By changing the second mortgage standard from 10-years to 30-years very little money ends up going to principal. At 30 years for $100k at 7% about $73 of a $667 payment goes to principal compared to about $330 going to principal when the mortgage is restricted to 10 years and $57k. At the end of a year the prudent lending standard has the homeowner roughly $4k less indebted with the second mortgage. This is $4k of reduced risk for the mortgage holder. Further, there is no way homes would have been bid up to today's prices and affordable homes are more likely to retain their value than unaffordable home.