dwot (99.56)

The Debt

November 20, 2011 – Comments (8)

Financial Armageddon has a post that shows a graph for debt from the 1950s to now.

The debt levels started taking off in the 80s, right when Greenspan started stepping down the interest rates.  I think  of debt as taking from future jobs.  The money you have to pay back is not available for goods and services that would provide work for people.

The entire policy around lending based on being able to borrow to a level of debt that can be serviced with a fix percent of income when rates are not fixed and further, their properties as they change are not linear, but exponential is insane and completely lacks numeracy common sense.

Overwhelmingly when you read about the the issue the problem being reported is the debt levels, however, that isn't the problem, it is a symptom of bad policy.  The problem is how what you qualify to borrow is calculated.  The entire policy shows low numeracy in terms of the dynamic nature of interest rates.

What you qualify to borrow should be a fixed number times the income.  I would suggest that it should also be say 3 times the higher income partner and 1.5 times the income of the second person in a relationship.  So, if you have a couple with $60k and $40k, the maximum debt would be $240k.  The reason I don't think both incomes should contribute the same is that couples tend to have families and have one partner not making income for periods of time and relationships break up.

Now, working within the maximum amount you are allow to borrow based on a multiplyer times income, then the policy on the maximum that you can pay should be based on a fixed percent of income.

Looking at the example of the couple with $100k of household income that qualify to borrow a maximum of $240k and then for simplicity say the maximum of income that you can have going to debt servicing is 30%, so you can have $30k of mortgage payments per year or $2500/month.  At 4% if you opted to pay the maximum allowed you'd have about an 10 year amortization for the mortgage.  At 12% you'd have about a 27 year amortization paying the maximum.  That same family at 4% could also choose to pay say $1200/month and have an amortization of about 28 years.

But I also think the maximum years for amortization should be less when interest rates are lower 30 at 12% and one year less for each 1% decline in the interest rates, so maximum of 22 years at 4%, which would give a monthly payment around $1375.

Long term debt is simply bad for the economy.  I can guarantee at 12% people are motivated to reduce debt and will make sacrifices to reduce that debt and they will dramatically reduce the amortization period without policy forcing it down.  At 12% increasing the payment by 10% would make the amortization period go from about 27 years to just over 17 years.  The interest savings is over $200k for a relatively small sacrifice.  At 4% there isn't the same motivation which is why it is important to reduce the maximum allowed amortization period for lower rates.