Why not refinance when interest rates rise?
Interest is the relative price of present vs. future assets. The higher the interest rates, the more future assets cost in terms of present assets. When you take out a loan you are buying present assets by paying future assets, and the lower the interest rate the better for you. Once you have taken out a fixed rate loan, however, you hold present assets and owe future assets, and it seems you should prefer higher interest rates. Thus when interest rates rise that should be good news for you, and when interest rates fall that should be bad news. So why do homeowners act like falling rates are good news, and why are they so much more eager to refinance loans when rates fall rather than when rates rise? Am I missing something? For example, if you borrowed $100,000 at 7% interest, owing $7000 per year forever, and then interest rates rose to 10%, then you should be able to get someone else to take over your $7000 per year obligation for only $70,000. So you should be able to refinance, make the same loan payment, and have $30,000 more equity in your house. Robin Hanson [EMAIL PROTECTED] http://hanson.gmu.edu Asst. Prof. Economics, George Mason University MSN 1D3, Carow Hall, Fairfax VA 22030- 703-993-2326 FAX: 703-993-2323
Re: Why not refinance when interest rates rise?
Robin, Note that you can't be better off "refinancing" since your payments continue to be $7000 a year - thus consumption never rises and your puzzle must involve an illusion! So where is it? Run your example in reverse. You borrow $70,000 at 10% paying $7000 per year forever. The interest rate then falls to 7%. You thus borrow $100,000 at 7% and, *following your logic*, you now take $70,000 of the new $100,000 and pay off your loan giving you a savings of $30,000. Great, but wrong! You owe the bank $7000 per year which at a 7% interest rate now has a NPV of $100,000 - you therefore must give the bank $100,000 not $70,000. No gain. The key is that the NPV of the $7000 per year is $100,000 at a 7% interest rate but only $70,000 at a 10% interest rate so *regardless* of whether you "refinance" or not the real value of your mortgage changes with the interest rate. Essentially, what refinancing does in your example is to reflect the real changes in nominal terms which otherwise would not occur. What you should do when the interest rate goes up is save more - that is the only source of gain. Alex -- Dr. Alexander Tabarrok Vice President and Director of Research The Independent Institute 100 Swan Way Oakland, CA, 94621-1428 Tel. 510-632-1366, FAX: 510-568-6040 Email: [EMAIL PROTECTED]
