Low Interest Rates – The Two Faces of Dr Jekyl and Mr Hyde
High debt levels at low interest rates will do more to stagnate the economy and for much longer than people realise. Commonly held beliefs that low interest rates are good for the economy are simply poorly thought out and blatantly false. The only benefactors are those who borrowed at higher rates that they could afford at higher rates and they have now increased their disposable income by refinancing. When rates are first lowered, there are far more people who benefit then the new borrowers who are hurt. In the short term there is the appearance that low interest rates are helping the economy. However, lending standards do not consider the Mr Hyde part of lower rates. Lending standards are based on a percent of income to service debt without any consideration as to the exponential growth of default-risk as rates decline. Borrowers borrow to a percent of income that has an acceptable risk at higher rates but falls apart at lower rates. Lending ought to be based on risk, not percent of income. What happens to those not yet established is that debt gets bid up to what the bank will lend and with the bidding asset prices like homes increase. Adding to the insanity of loaning out grossly increased principal for the same level of income, percent of allowable income has been increased with microscopic increases in insurance. Or, the length of the mortgage is increased to as much as 40 years. The following table shows that at 30% of income with the insane lending standards a borrower qualifies for 278% of the principal at 2% compared to 12%. When percent of income is raised to 50% and rate reduced to 2% the difference is 464%.
Principal Allowed for 30% of 100k of income.
It ought to be intuitive that there would be more risk loaning more principal for the same income level. The fact that there is less interest to pay on the debt makes some allowance to allow more money to be loaned for the same level of income, but certainly not the increases the table shows. The biggest problem with low interest debt to 30% of income in comparison to high interest debt at 30% of income is the ability to reduced debt burden. Both repayment plans over 30 years require $900k of payments, but at 12% only 27% of the $900k is principal compared to 75% at 2%. At high interest rates 73% of what is being paid is interest and that can be reduced. At low interest rates only 25% is interest and there is far less ability to reduce total burden. The next table shows the gross difference in payment reduction with manageable increases in payment of 10 and 20%. At increasing payments a mere 10% when rates were a high 12% more then 1/3rd of
the repayment burden is eliminated. At 2% interest repayment burden is reduced by a factor of 10, to a mere 3.4%. Interest Savings From Increased Debt Repayment
An additional possible benefit for a high interest borrower is that there may be the opportunity to refinance at a lower rate. A low interest borrower has very little chance of debt relief there as well. It also works out that there is far more benefit from being able to refinance lower when rates were high than when rates are low. So, additionally, as interest rates are lowered the benefit of refinancing is reduced. Take two households 3 years apart, the first had 12% to qualify and the second had 10% to qualify. Say the rate declines 2% for each. So, the home was not bid up for the 12% buyer and the mortgage was $243k and the payments were $2500/month. To simplify, lets say the very next day they homeowner was able to lock in at 10% instead. Keeping their payments the same, they drop down from a 360month amortization to a 200-month amortization when payments remain the same. This is the stuff that dramatically stimulated the economy with initially dropping interest rates. That 2% decline in interest with the homeowner just maintaining their payment saves them a whopping $400k of interest.
Now look at the homeowner that came along three years later when rates were 10%. Home price got bid up to $285k, but they get the same lucky deal where the very next day they get to lock in 2% less at 8%. They kept their payment the same as well. They benefit, but their amortization only reduces to 214 months. Their savings in interest is $365k, still very good, but that is almost a 10% decline in leverage for savings. At 8% that declines to 6% the amortization declines to 228 months for $330k savings, and 6% that declines to 4% has an amortization decline to 243 months for a $293k savings. Declining leverage of reducing rates
The low interest borrower loaned the maximum with the same lending standards as used for high interest borrowers is grossly disadvantaged with few options to get ahead of the debt. Additionally, the low interest debt also tends to suppress wages, as borrowers are not economically empowered to be active in the economy. Their disposable income is limited and it leads to weak wages and greater likelihood of job disruptions. This is the stuff of long-term economic stagnation. The solution is to tighten lending standards as rates decline.