Counterintuitive thought about mortgages

[egslim]

Another part of the eqation is what the value of your property is going to be, what your credit rating will be and what deals are on offer when your fix expires.

That part of the equation is unknown, since accurately predicting the future is impossible. So you're best off covering yourself against contingencies.

 

[JoeTheJuggler]

Which is better - steak or lobster?

In other words, there is no correct answer.

I don't think "better" is synonymous with more or less "risky". As drkitten and Aepervius (and probably others) have pointed out, an adjustable rate is obviously more risky.

Whether or not that is "better" for a certain individual in a certain situation is another question.

 

[pgwenthold]

I think you're confusing nonzero interest rates with consistently rising interest rates. It is true that inflation is likely to be perennial, but extremely unlikely that inflation rates will rise consistently.

No, I was talking about the cost of mortgages in real dollars. We'll just talk about fixed rates now. It applies to adjustable rates, too, but that has variation. If I have a mortgage that costs me $1000 a month, that will still be $1000 a month 30 years from now. Meanwhile, the cost of living will have gone up over that time (inevitably - as I asked, has there ever been a 30 year period with net deflation?). I usually compare it to a rental. So if rentals are running $700, and my mortgage is $1000 a month, then it would be cheaper to rent. However, if I intend to stay (as DrKitten points out, this is not always the case), and if rental rates just follow inflation (call it an average of 3%), then 30 years from now I will still be paying $1000 but rent would cost $1650, so I am getting off way cheaper. And regardless of the inflation rate, as long as there is inflation over 30 years, my $1000 costs less in year 30 than it does in year 1. The only way my mortgage costs more in the end (in real costs) is if there is net deflation. That was what I was talking about.

Now, throw a variable rate mortgage in the mix and it gets more complicated, with my montly payment no longer always $1000. Others have discussed the possibilities, but if, for example, interest rate increases are associated with high inflation, then that hurts the value of my ARM, because you don't get the benefit of the inflation in terms of real cost.

 

[drkitten]

No, I was talking about the cost of mortgages in real dollars. We'll just talk about fixed rates now. It applies to adjustable rates, too, but that has variation. If I have a mortgage that costs me $1000 a month, that will still be $1000 a month 30 years from now. Meanwhile, the cost of living will have gone up over that time (inevitably - as I asked, has there ever been a 30 year period with net deflation?). I usually compare it to a rental. So if rentals are running $700, and my mortgage is $1000 a month, then it would be cheaper to rent. However, if I intend to stay (as DrKitten points out, this is not always the case), and if rental rates just follow inflation (call it an average of 3%), then 30 years from now I will still be paying $1000 but rent would cost $1650, so I am getting off way cheaper.

Then, not to put too fine a point on it, your mortgage broker is an idiot and doesn't know how to set rates.

The whole point of interest is to compensate the lender for the joint risks of predicted inflation and of possible default in repayment. You can see this from the way that interest rates tend to correlate with inflation; higher inflation means that the principle loses more buying power, so you (generally) pay more in interest to compensate the lender.

If your rental is $700 now, but rent is expected to be $1650 then, I can easily set my mortgage interest rate so that the payment right now is $1650 and will remain so -- and you'll not only not be getting off "way cheaper," you'll actually be paying substantially more over the length of the mortgage, but you'll also be building equity. Heck, I can set interest rates so that you pay $2000 a month, and I end up getting much more in cash -- but you own the house at the end.

There is, of course, a sweet spot, a point where the additional money you pay in interest exactly balances the expected inflation. Ideally, that's where I will set my (fixed)-interest rate, or more likely, a little higher to balance out the chance that you will fail to repay.

And regardless of the inflation rate, as long as there is inflation over 30 years, my $1000 costs less in year 30 than it does in year 1. The only way my mortgage costs more in the end (in real costs) is if there is net deflation.

No. It can also cost you more if you pay a high (fixed) rate of interest.

What will end up saving you money, in the long run, is if inflation rises above my expectations. What will end up costing you money, in the long run, is if inflation drops below my expectations.

Expected, stable inflation is simply priced into loan terms. It's unexpected or unstable inflation that causes problems.

 

[Brainster]

There was the great deflation from 1870-1890 or so, which isn't quite thirty years but is still a pretty long period of time, which arose from the US government paying off the Civil War debt.

 

[drkitten]

That part of the equation is unknown, since accurately predicting the future is impossible. So you're best off covering yourself against contingencies.

But it's equally unknown for fixed and variable rate mortgages. So from a comparative perspective, it doesn't matter.

 

[blutoski]

No, I was talking about the cost of mortgages in real dollars. We'll just talk about fixed rates now. It applies to adjustable rates, too, but that has variation. If I have a mortgage that costs me $1000 a month, that will still be $1000 a month 30 years from now. Meanwhile, the cost of living will have gone up over that time (inevitably - as I asked, has there ever been a 30 year period with net deflation?). I usually compare it to a rental. So if rentals are running $700, and my mortgage is $1000 a month, then it would be cheaper to rent. However, if I intend to stay (as DrKitten points out, this is not always the case), and if rental rates just follow inflation (call it an average of 3%), then 30 years from now I will still be paying $1000 but rent would cost $1650, so I am getting off way cheaper. And regardless of the inflation rate, as long as there is inflation over 30 years, my $1000 costs less in year 30 than it does in year 1. The only way my mortgage costs more in the end (in real costs) is if there is net deflation. That was what I was talking about.

Now, throw a variable rate mortgage in the mix and it gets more complicated, with my montly payment no longer always $1000. Others have discussed the possibilities, but if, for example, interest rate increases are associated with high inflation, then that hurts the value of my ARM, because you don't get the benefit of the inflation in terms of real cost.

Hm. Variable rate usually keeps the fixed monthly payment at $1,000 regardless of interest rate changes. What a higher interest rate does is mean the $1,000 covers more interest than before. Ultimately, the total amortization is increased. Lower interest rate means you're paying more principal in the $1,000.

Normally, I think it's advised to set your monthly payments to what you can offord. That's the starting point.

 

[pgwenthold]

Hm. Variable rate usually keeps the fixed monthly payment at $1,000 regardless of interest rate changes. What a higher interest rate does is mean the $1,000 covers more interest than before. Ultimately, the total amortization is increased. Lower interest rate means you're paying more principal in the $1,000.

So it's also a variable term, then?

Normally, I think it's advised to set your monthly payments to what you can offord. That's the starting point.

What I could afford in year 1 is very different from what I will be able to afford in year 30. For a variety of reasons. But that would even be the case if I were working in the same job and had only cost of living raises tied to inflation.

Of course, you are also free to pay down the principle if you can afford to pay more, so that you don't make it to year 30, but you don't have to.

 

[pgwenthold]

No. It can also cost you more if you pay a high (fixed) rate of interest.

More compared to what?

I am talking about the cost of my mortgage NOW compared to the cost of the mortgage in 30 years. Because of the fixed payment, my mortgage payment costs me more now than it will 30 years from now in real terms. That is true regardless of the interest rate, but is only true if there is net inflation.

If you are making some other comparison, then it is not what I am talking about.

 

[drkitten]

I am talking about the cost of my mortgage NOW compared to the cost of the mortgage in 30 years.

Ah. I'm talking about the comparison you made, between rental costs and mortgage costs, which I think was your implicit comparison in "30 years from now I will still be paying $1000 but rent would cost $1650, so I am getting off way cheaper."

Because of the fixed payment, my mortgage payment costs me more now than it will 30 years from now in real terms. That is true regardless of the interest rate, but is only true if there is net inflation.

That's true, but not necessarily relevant, because you pay interest up front on the balance of the mortgage. So your payment thirty years from now will be $1000, but only because you already paid $650 (or its equivalent) in interest on the mortgage in the first few months. So the pre-paid interest plus the payment you make at the end of the mortgage term still ends up costing you the same in real terms as if you had set up a schedule of increasing instead of fixed payments.

 

[blutoski]

So it's also a variable term, then?

That's very rare.

You'd have the same $1,000 payments, and the portion that goes toward principal is usually low at the beginning, but rises over time.

When you roll over the mortgage or obtain a new one, there will be a remaining principal, and if interest rates rose, it will be higher than you originally calculated. But you're still out of your mortgage in 5 years.

What I could afford in year 1 is very different from what I will be able to afford in year 30. For a variety of reasons. But that would even be the case if I were working in the same job and had only cost of living raises tied to inflation.

Yes, but for some reason, you were comparing rental with some sort of monthly mortgage payment. Generally, you can afford $1,000 for housing or you can't. The rental and mortgage payments will be the same for a particlular person. It's a question of what you get for your $1,000, and that includes a lot of intangibles such as pride in ownership, and capital gains.

Since housing prices are rising faster than the rest of inflation and also rising faster than wages, it is always logical to buy based strictly on these three factors. But there are other factors, so I can't say that it's always logical to buy.

 

[pgwenthold]

Ah. I'm talking about the comparison you made, between rental costs and mortgage costs, which I think was your implicit comparison in "30 years from now I will still be paying $1000 but rent would cost $1650, so I am getting off way cheaper."

Nah, that was just my way of showing that you are paying less each month for housing at the end of the term than you would be if you were just paying rent during an inflationary term.

The comparison of rent vs mortgage costs is a lot more complicated, and making up numbers for a starting point is not a basis for serious analysis.

That's true, but not necessarily relevant, because you pay interest up front on the balance of the mortgage. So your payment thirty years from now will be $1000, but only because you already paid $650 (or its equivalent) in interest on the mortgage in the first few months. So the pre-paid interest plus the payment you make at the end of the mortgage term still ends up costing you the same in real terms as if you had set up a schedule of increasing instead of fixed payments.

But if I had a schedule of increasing payments, I wouldn't be talking about the cost 30 years later. Shoot, when would that be paid off? Year 10? 12? Probably somewhere in there.

However, I think my rent comparison kind of shows your point. Yeah, I am paying a lot less for housing in year 30, but because I paid more up front. In the scenerio I gave, it would take an inflation rate of 1.25% to break even on the end of the term payment. However, it needs to be 2.5% to break even on the total cost over the full term, although that is not taking into account the equity. If this is a $100K house, and still worth $100K at the end of the term, then the inflation only needs to be .25% for me to come out ahead. And if the housing market increases at the inflation rate, that rate only needs to average 0.125% over the 30 years.

Of course, this is why rental property can work as an investment, even if the rent charged is merely enough to cover the mortgage.

 

[drkitten]

But if I had a schedule of increasing payments, I wouldn't be talking about the cost 30 years later.

Why not? You can set up a schedule of payments for any timeframe you like. Borrow $300,000 and pay it off at $1000/month (increasing at 3% per year) for thirty years.

Shoot, when would that be paid off?

Year thirty, by construction....

The "cost of the mortgage in real terms" is a fairly complicated calculation, precisely because with a typical mortgage, you're paying more than the house is worth in the first few years, and substantially less in the last. The payment schedule is set up to reflect this, with the expected inflation rate figured into the interest rate that you're charged.

The end result, of course, is that you pay much more than the nominal cost of the house --- and typically much more than the nominal cost of the house, even at the end of the mortgage. This more than compensates the lender for whatever rate of inflation he expects over the term of the mortgage.

Where the trouble comes in is if there is unexpected inflation. If interest rates are set assuming 3% inflation, but there is "really" only 2% inflation, then the mortgage holder's real costs will be substantially higher than expected, and of course, vice versa. So you can end up losing substantial amounts of real money on a fixed-rate mortgage even without deflation.

 

[drkitten]

That's very rare.

You'd have the same $1,000 payments, and the portion that goes toward principal is usually low at the beginning, but rises over time.

When you roll over the mortgage or obtain a new one, there will be a remaining principal, and if interest rates rose, it will be higher than you originally calculated. But you're still out of your mortgage in 5 years.

I'm not understanding, then.

I take out a 30-year ARM with a monthly payment of $1000. Next month, the bottom falls out of the market and interest rates triple.

I'm still paying $1000 per month. I'm still out-and-done in thirty years (360 payments). So my total payment is $360,000 regardless of interest rates.

What "adjusts"?

My understanding is that when interest rates go up, your payment goes up. (" 1-Year Adjustable Rate Mortgage : This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 12 months on the anniversary of your loan.") The only loans I've seen where the payment is fixed are the "balloon" loans where you pay what you can for five years and then skip town just before the bank tells you that you still owe $108,000 on your $100,000 house.

 

[pgwenthold]

Why not? You can set up a schedule of payments for any timeframe you like. Borrow $300,000 and pay it off at $1000/month (increasing at 3% per year) for thirty years.

Oh, that's a different ballgame. I thought you were talking about increasing your payments on your initial $100K mortgage (our $1000/month scenerio). That explains better your comment about loading interest payments up front in a fixed payment schedule.

Do companies do this type of "real cost fixed" mortgage?

 

[pgwenthold]

I'm not understanding, then.

I take out a 30-year ARM with a monthly payment of $1000. Next month, the bottom falls out of the market and interest rates triple.

I'm still paying $1000 per month. I'm still out-and-done in thirty years (360 payments). So my total payment is $360,000 regardless of interest rates.

What "adjusts"?

My understanding is that when interest rates go up, your payment goes up. (" 1-Year Adjustable Rate Mortgage : This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 12 months on the anniversary of your loan.") The only loans I've seen where the payment is fixed are the "balloon" loans where you pay what you can for five years and then skip town just before the bank tells you that you still owe $108,000 on your $100,000 house.

Yeah, if you are still "out of your mortgage" after a fixed term, what it would have to mean is that you might be left with some balance. But that still means that the balance is due at the end of the term. You may have to get another loan to pay off the balance.

BTW, what is the distinction between a mortgage and other types of loans? You can have cars that are more expensive than houses, so what makes one a mortgage and another just a loan?

 

[drkitten]

Oh, that's a different ballgame. I thought you were talking about increasing your payments on your initial $100K mortgage (our $1000/month scenerio). That explains better your comment about loading interest payments up front in a fixed payment schedule.

Do companies do this type of "real cost fixed" mortgage?

Not typically, no. The default risk would be unacceptably high, lenders prefer to get their money up-front (avoiding the discount problem) and consumers wouldn't go for the ever-increasing schedule of payments. It's purely a thought experiment.

But it's a very useful thought experiment precisely because it shows how one overpays in the early stages of a conventional mortgage and underpays at the end, irrespective of interest rates. Therefore, neither the real cost of the first payment nor the real cost of the last payment reflects much about the actual real cost of the mortgage as a whole.

So there are two parameters involved. The seller typically sets the nominal price of the house, because the seller gets his money at closing, when the real price and the nominal price are identical. The lender sets the real price of the house, because the lender is the one being paid back over time, and he uses the interest rate to control what the real price is.

If the seller and the lender are the same person, you can get all sorts of bizarre things going on. I could, for example, sell you my house for ten dollars, at a hundred thousand percent interest. If my calculations are correct, you would pay about $850 a month, all of it interest, and have a final payment of $10 thirty years from now. And I think we'd both be happy with that deal. Indeed, you might be even happier with that deal than you would be with a conventional mortgage. You now have a bill of sale for $10 on the house, which you can use to lower your property taxes, and all of your house payments are deductible as mortgage interest.

But all this really shows is that "inflation," per se, has little effect on the value of a mortgage, if it's properly taken into account at the start. I can set the (planned) real value of the mortgage independently of the nominal value. It's the difference between the planned real value and the unplanned real value (i.e. what actual inflation is) that causes problems all around.

 

[drkitten]

BTW, what is the distinction between a mortgage and other types of loans? You can have cars that are more expensive than houses, so what makes one a mortgage and another just a loan?

Linguistic. mostly. The same reason that old men have grey hair while old women are platinum blondes.

There's also a whole body of case law dating back to medieval times about mortgages that obviously do not apply to medieval automobiles.

One of the big (legal) issues, for example, is "who owns the [mortgaged] land"? There are two obvious answers, both obviously wrong. For example, the land might be owned by the lender until the debt is paid off. Unfortunately, this means that (for example), if the lender goes bankrupt ten years from now, his creditors now own the mortgaged land, and who preserves the rights of the borrower (what the creditors want to keep the land)?

The alternative (which is more common today) is that the borrower actually owns the land and the lender has a lien or something on it. The problem with this, of course, is fraudulent conveyance. I mortgage the properly, turn around and sell it for ten bucks to my cat, and default on the mortgage. You can't get the money from me, but you can't get the land back, either, because I no longer own it.

So, way back when, the main difference between a mortgage and a loan was that a mortgage was written using the first legal theory, a conventional loan with the second. Since this made so little sense that even the legislature eventually noticed, most jurisdictions have cleaned this matter up.

 

[drkitten]

How odd. The fairies are evidently posting for me.

 

[blutoski]

I'm not understanding, then.

I take out a 30-year ARM with a monthly payment of $1000. Next month, the bottom falls out of the market and interest rates triple.

Maybe it's different in Canada: I've never seen a 30-year mortgage here. I have seen a 5-year mortgage, with payments based on a 30-year amortization at the prevailing rate. If it's a fixed rate, neither the payments nor the amortization will change. If it's an adjustable rate, the payments stay the same, but they're covering less principal and more interest, so 5 years in, your new mortgage may require a 26-year amortization to stay at $1,000/mo payments.

My understanding is that when interest rates go up, your payment goes up. (" 1-Year Adjustable Rate Mortgage : This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 12 months on the anniversary of your loan.") The only loans I've seen where the payment is fixed are the "balloon" loans where you pay what you can for five years and then skip town just before the bank tells you that you still owe $108,000 on your $100,000 house.

Ah. You're talking about a mortgage that covers the entire amortization period. In this situation, I can understand why they'd have to increase the payments if the interest rates change.

However, I've never met anybody who has agreed to a 30-year term. That is extremely risky, because you're locked out of re-negotiating for better terms down the line. As a consequence, it's very rare these days. They were very common in our grandparents' era. I think what happened is that the high interest rate phase in the '80s put too many people out of their homes because they increased the payments instead of extendig the amortization, so people are wary of that type of agreement.

The strategy with which I'm familiar is to sign up for between 1 and 5 years at a fixed or variable interest rate, but the payments don't change. Increases in interest rates mean you pay off the mortgage later; decreases in interest rates mean you pay off the mortgage sooner.