Mortgages and Inflation, 3/20
The 30-year Fixed Rate has a problem
Suppose that you earn $72,000 a year and you need a $300,000 mortgage. If you can get a 30-year, fixed-rate mortgage at 4.0 percent, the monthly principal and interest cost is $1432 (although your total mortgage payment will be higher, because your lender will want to include escrow for property taxes and insurance). Relative to your monthly income of $6000, the cost of $1432 is less than 25 percent, which is manageable.
But suppose instead that the mortgage rate is 12.0 percent. Then your principal and interest will cost $3086, or more than half your income. That is more than you can afford, and more than the lender will allow you to take on.
But the only reason for mortgage rates to hit 12 percent is if inflation is almost that high. And if inflation is, say, 10 percent per year, buying the house is still a good deal. If your income goes up at 10 percent per year, then in five years your monthly income will be $9663, and the monthly principal and interest of $3086 will be much less of a strain. And in another five years, you will have lots of income to spare.
The thirty-year, fixed-rate mortgage behaves well when inflation and interest rates are low. When inflation and interest rates are high, it forces you to make payments in the first few years that are high relative to your income, with the strain on your income declining rapidly after those first few years.
This is called the “payment tilt” problem. That is because, relative to inflation, a 30-year fixed rate mortgage tilts your payments to be more burdensome early and less burdensome later on.
We do not have the “payment tilt” problem at the moment. Right now, mortgage interest rates remain around 5 percent, with the latest inflation figures around 8 percent. If inflation, including inflation in home prices, is going to remain that high for several years, then home buyers are going to make out like bandits. But I do not think that is sustainable.
If high inflation persists, and markets adjust, chances are we will see interest rates rise to 10 percent or more. That will make the 30-year fixed-rate mortgage unaffordable for the typical home buyer, because of payment tilt.
The last time we had high inflation and interest rates, in the 1970s, many mortgage innovations were introduced. Adjustable-rate mortgages (ARMs) were one example, because the interest rate on an ARM is tied to short-term interest rates, which typically are below long-term rates. But if short-term rates also are high, then ARMs do not solve the payment-tilt problem.
Solving the payment-tilt problem requires reducing monthly payments in the early years of the mortgage in exchange for higher monthly payments later. The many innovations of the late 1970s and early 1980s had such a structure. It leads to what is called “negative amortization.”
The reason that the 30-year fixed-rate was introduced in the first place was to ensure that the borrower’s outstanding debt would decline over time. Gradually paying off the principal is known as amortization.
Prior to the 1930s, many mortgages required only interest payments, with the entire principal due after, say, 5 years. These “balloon” mortgages resulted in many foreclosures in the 1920s, and policy makers wished to avoid a repeat. They steered America toward amortizing mortgages instead.
Negative amortization means that the borrower’s outstanding debt does not decline over time. It does not even stay the same. Instead, it increases. Getting rid of “payment tilt” also means allowing the mortgage principal to grow each year. A growing principal is what constitutes negative amortization.
Negative amortization is workable as long as inflation keeps up. Essentially, both the borrower and lender are betting that inflation will keep the borrower’s income rising and boost the value of the house as collateral at least enough to match the scheduled increase in the size of the mortgage debt.
The TL;DR is that the mortgage market can adapt to inflation, through creative alternatives to the 30-year fixed-rate loan. But the cognitive load on borrowers and lenders rises, as they assess the payment patterns and risks of alternative mortgage instruments.
I was a kid in the 1970s. I recall the high (at the time) gas prices. I recall my good income parents fretting constantly about inflation and taxes and the enormous effort they made to economize. They shopped groceries in bulk (we had a large family) and had a garden.
But looking back I think much of their economic consternation was a product of attitudes imprinted on them in their youth from the Depression and WWII rationing. I think that because I also recall my dad's coworkers - who would be in no better financial condition - owning lake houses and boats. I grew up "money poor" in an upper income household because my parents lived as if they would be impoverished at any moment. Now, this financial hypochondria did pay off in my parents retirement as they have always had the money to afford very good care
The financial attitudes of today held by most Americans are the polar opposite of those imprinted on the children of the Depression and WWII scarcity era. Ours is a society of "have it now, have it without consequences" opulence. Well, that is the attitude of the affluent upper half.
But consequences will come, right? The bills will come due, won't they? Or is the can that durable and the road so long the can kicking goes on forever?
My first mortgage in 1977 (UK) variable rate was 16%. Inflation was 22%, average wage settlements in unionised businesses was 14%, income tax base rate was 35%, then fairly narrow tax bands with 5% increments up to top rate 83%, reduced from 85% when a 15% supertax was introduced on unearned income to give top marginal rate of 98%. Corp tax rate was 60%.
This was post-war Socialist Britain with all key industries State-owned. The madness only ended after 1979 when Margaret Thatcher was PM and rolled back the Socialist State - incompletely as she left too much of welfarism intact.
Those who think a Socialised, centrally planned and controlled economy - which is what the Green Deal/Net Zero Carbon is - can be paid for by higher taxes and massive debt, are ignoring history.
I am getting a strong sense of déjà vu.