Ed Dodson responding...
Robin Hanson wrote:
> 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.
Ed Dodson here:
A borrower owing money to a bank and paying a fixed rate of interest
in a rising interest rate environment may or may not be in a better
position. The unknown is whether rising interest rates are related
to a general rise in prices of goods and services or simply a
response to a general contraction of credit availability. There are
other variables as well, such as the net effect on taxable income of
the mortgage interest deduction and the market rate of return on
savings and investments. If banks and money market funds are paying
increasing rates of interest, a person with liquid assets would be
more inclined to invest those funds elsewhere rather than reduce the
outstanding loan balance via a curtailment.
>
>
> 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?
Ed Dodson here:
The financial benefit of refinancing depends upon several factors:
(a) the actual reduction in the rate of interest achieved by
refinancing; and (b) the length of time the person plans to remain
in the same residence. These are important variables in determining
how quickly actual savings are realized given the fees associated
with a refinance transaction. A typical recent refinance would
involve a rate from from, say, 9-1/2% to 7-1/2%, which might achieve
an immediate cash flow benefit of a $250-$300 reduction in the
monthly mortgage payment; or, the homeowner might reduce the term
from 30 years to 15 years with roughly the same total payment but a
much more rapid amortization of the principal.
Now, in a more rare situation, a homeowner who is a more aggressive
investor might pursue a cash-out refinance to take advantage of
equity in the property created by escalating property values. They
might accept the increase in interest rate from 7-1/2% to 9-1/2%
because they believe they can achieve after-tax double-digit returns
on investment in the stock market or in government securities. I say
that this is situation would be rare because the person inclined to
do so probably does not need to tap home equity in order to invest
elsewhere.
>
>
> 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.
Ed Dodson here:
You have lost me. A mortgage loan is an amortizing bond. If market
rates rise to 10% an investor would only pay the discounted value of
the loan.
>
>
> 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
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