Consider the case of a $250,000 mortgage over 25 years. In one scenario, the mortgage rate is 4% with 2% inflation, and in the other scenario, the mortgage rate is 7% with 5% inflation. Here are the monthly payments in each case along with the inflation-adjusted real value of the last payment:

**Scenario 1**: $250,000 mortgage, interest rate 4%, inflation 2%

Monthly payment: $1315

Real value of last payment: $803

**Scenario 2**: $250,000 mortgage, interest rate 7%, inflation 5%

Monthly payment: $1751

Real value of last payment: $519

Initially, the scenario 1 payments are much more affordable. However, by the end of the mortgage, the scenario 2 payments are lower in real terms. In the low inflation case, people are enticed into larger mortgages with lower payments, and these payments stay fairly high in real terms (after inflation) over 25 years. In the higher inflation case, people are forced to take smaller mortgages, but get more relief in real terms over time.

So its not just today’s lower interest rates allowing people to take on big mortgages that make mortgages riskier. The fact that payments remain higher in real terms over the life of the mortgage means that the risk of default stays higher over time. People who bought homes in the 1980s suffered with high interest rates, but at least the real value of their mortgage payments eroded quickly due to high inflation.

The other significant factor is that you don't necessarily have your initial mortgage rate over the entire amortization period. Typically, you'll have a rate for 1 to 5 years. If interest rates rise then the mortgagor will be renegotiating to a higher rate which he or she may or may not be able to affort. Essentially it's the same problem as with ARM mortgages except the higher rates are imposed by the prevailing economy as opposed to a contractual agreement.

ReplyDelete@MMorgan: That's a significant factor. So, with inflation and interest rates low, the probability of rates rising is higher than it was in the 1980s and simultaneously, today's mortgage debts erode due to inflation slower.

ReplyDeleteIn both of your examples, the mortgage rate was 2% over the rate of inflation. I wonder which one pays more in real dollars over the life of the mortgage? My intuition says they'd be pretty close, but I haven't done the math yet.

ReplyDelete@Returns Reaper: My guess is that scenario 2 (higher inflation and interest rate) would lead to lower overall real dollars paid because larger payments come up front.

ReplyDeleteI think the more relevant point is that the beneficial effect of inflation is reduced when your mortgage term is significantly shorter than the amortization period. For example, if the inflation rate rises significantly then it is true that your mortgage debt erodes more quickly because you are paying with less valuable currency. However, the next time you have to renew your mortgage, the rate will go up to reflect the increase in inflation and therefore the erosion will be offset by that higher rate. I don't think your simulation takes this into account because it seems to assume a constant interest rate over the entire 25 year period. Your similation would be entirely accurate for debt-phobes who have a five year mortgage and who pay it off during the intial term. :)

ReplyDelete@MMorgan: In a scenario where inflation rises, the benefit you get is limited to your mortgage term, as you say. However, the scenarios I describe are intended to show the difference in two scenarios even when inflation stays constant throughout the life of the mortgage in each scenario.

ReplyDeleteThe real value of the last payment is interesting - do you have a sense of what the real value of the total payments would be as between the two scenarios (i.e. how much is paid in real dollars in each scenario when you include interest payments and does that affect the risk)?

ReplyDelete@Returns Reaper and @MMorgan: Because 2 people asked about the total real value of the payments in each scenario, I sparked up my spreadsheet again.

ReplyDeleteTotal payments in real terms:

Scenario 1: $310,906

Scenario 2: $302,876

As I suspected, the total real payments is lower in the higher inflation case because the initial payment is higher so that the real balance owing is lower over the life of the mortgage. This is another way of seeing that the risk of default later in the mortgage life is lower in the higher inflation case.

Now before we start wishing for higher inflation, we need incomes to keep pace with those kind of numbers to make the scenario work.

ReplyDelete