Bankruptcy

That Low Interest Rate May be Higher Than it Appears

By Christian E. Weller

The other day I listened to an ad, where a mortgage bank was arguing that, although mortgage interest rates have recently gone up, they are still relatively low at historical rates. Never mind the wisdom of fighting a crisis of too much leverage with more leverage, consumers hopefully have learned their lesson from the past few years that it matters if they can afford the mortgage payments in the future, not just in the first month. And, current economic data show that mortgage payments are probably less affordable now than at any point in the past four years.

The affordability of the mortgage is determined not just by the interest rate on that mortgage, but also what we can expect to happen to prices over the life of the loan. If prices go up, incomes will presumably rise in tandem and thus make it easier to afford the fixed mortgage payments. The opposite is true, when inflation is slowing. Then, nominal income growth will also be slow and fixed mortgage payments relative to income will also stay comparatively high.

Nowadays, we have some sense of what the markets think inflation will be over the next few decades, when a borrower will repay the mortgage. The U.S. Treasury has been issuing inflation protected Treasury bonds since July 2004. The difference between the interest rate on an inflation indexed 20-year Treasury bond and a 20-year Treasury bond that is not inflation adjusted is the market's long-term inflation expectation. In recent months, this inflation expectation has fallen from 2.6% in June to 2.1% in September -- the lowest since the Treasury started issuing inflation adjusted Treasury bonds -- thus making mortgages presumably less affordable over the long run.

Even as mortgage rates stayed the same during these three months, the affordability of mortgage payments declined, because the expected inflation dropped. And all signs suggest that mortgage interest rates probably are not declining in October. At the same time, lower oil prices and a slowing economy will also reduce the market's long-term inflation expectation or at least keep it level. If inflation expectations stay the same as in September, though, and mortgage interest rates stay at the average level of the past few months, the inflation adjusted interest rate on mortgages -- the one that really matters -- will be at its highest level since July 2004. So much for relatively low and affordable mortgage payments.

Full post as published by Credit Slips on October 19, 2008 (boomark / email).