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Why Nominal Interest Rates Matter

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I have mentioned this a few times, I learnt about this from someone here but I don't think it gets enough attention so thought I would explain it.

Firstly, nominal interest rate is the actual interest rate you see, ie the one the Bank of England sets. The real interest rate is the interest rate - the rate of inflation.

Theoretically the real interest rate does not change over time. Its essentially the benefit of deferred consumption, ie the reward someone will give you for not consuming now but consuming in the future. I think the figure of around 3% is bandied around by ecnomists.

The nominal rate however can be anything and will (or should) respond to inflation. If it dosen't then people will just move their money out of the currency or either save everything or spend everything. It will always go back to a balance.

Why does this matter in relation to mortgages. Ok, consider two different ways of having a real interest rate of 3%

PLAN: A

Inflation 7%

Interest rate: 10%

Income £1,500/month

PLAN B

Inflation: 2%

Interest rate: 5%

Income £1,500/month

Ok? These are *exactly* the same in real terms.

Now lets consider a person getting a mortgage. They have £1,500 a month. Lets say the decide they can afford to spend £1,000 on their mortgage over 25 years.

Now Plan A person can borrow £110,000 thousand pounds. (6 x after tax income)

Plan B person can borrow £171,000 (9.4 x after tax income)

Why the difference? Well this is the key bit. Because we are dealing with the nominal interest rate and not the real interest rate when we calculate the monthly payments, in a situation of high nominal interest rates - the person will be paying a higher % of their mortgage off in the early years. This means those early years are a constraint on that max £1,000 much earlier on.

But what is the difference?

Consider in 15 years time. The mortgage payments will be the same but what about incomes?

The person on Plan A will be earning (per month)

£1,500 * 15(^1.07) = £2,401

The person on Plan B will be earning (per month)

£1,500 * 15(^1.02) = £1,723

And this is the problem.

At the start of this example, both people where paying 66% of the after tax income on their mortgage (this is a little high which is why the mortgage/income was a bit high as well).

But after 15 years look what has happened. The person on Plan A is spending only 41.6% of the income on their mortage whereas the person on Plan B is spending 58% of their income on their mortgage.

And this is the major difference. When you get a mortgage in a low nominal interest rate situation you are going to be paying of that mortgage at a % of your income that is unlikely to change very much. It its always going to be a burder.

If however you get a mortgage in a high nominal interest rate environment, you can borrow a lot less. But, your mortgage as a % of income will rapidly drop over time.

Now, because house prices have, to some extent, been a function of access to finance - house prices have been driven up because we have moved to a low interest rate environment where people can borrow bigger sums. The problem is that in a low interest rate environment you should be spending a lower % of your income inititally because otherwise that % is not going to fall over time.

And that, to me, is the problem. Low nominal interest rates have had a large part to play in the house part boom because people don't realise what affect this is going to have on their repayments 10, 15 years down the line and take out big mortgages that they think won't be so big in the future - even though they will be.

The bad thing for those wanting a house price crash is that this might take a long time to feed through. When those who have bought houses on 60% income repayments started wanting to have kids, bigger houses etc thats when the major problems will start.

Comments? Sorry for rambling!

----

Oh, and this is why people should borrow according to their income, ie 3 or 4 times their income as opposed to their ability to make repayments. The latter is massivly affected by the nominal interest rate.

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You're correct, but then again I have a PhD and understand what you're saying.

The average person just doesn't give a ****. They only take into consideration the affordability of the first mortgage payment . :ph34r:

The other important factor is that at 10%, a 1% increase in IRs makes little difference. At 3%, a 1% hike kills you.

Edited by karhu

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I have mentioned this a few times, I learnt about this from someone here but I don't think it gets enough attention so thought I would explain it.

Firstly, nominal interest rate is the actual interest rate you see, ie the one the Bank of England sets. The real interest rate is the interest rate - the rate of inflation.

Theoretically the real interest rate does not change over time. Its essentially the benefit of deferred consumption, ie the reward someone will give you for not consuming now but consuming in the future. I think the figure of around 3% is bandied around by ecnomists.

The nominal rate however can be anything and will (or should) respond to inflation. If it dosen't then people will just move their money out of the currency or either save everything or spend everything. It will always go back to a balance.

Why does this matter in relation to mortgages. Ok, consider two different ways of having a real interest rate of 3%

PLAN: A

Inflation 7%

Interest rate: 10%

Income £1,500/month

PLAN B

Inflation: 2%

Interest rate: 5%

Income £1,500/month

Ok? These are *exactly* the same in real terms.

Now lets consider a person getting a mortgage. They have £1,500 a month. Lets say the decide they can afford to spend £1,000 on their mortgage over 25 years.

Now Plan A person can borrow £110,000 thousand pounds. (6 x after tax income)

Plan B person can borrow £171,000 (9.4 x after tax income)

Why the difference? Well this is the key bit. Because we are dealing with the nominal interest rate and not the real interest rate when we calculate the monthly payments, in a situation of high nominal interest rates - the person will be paying a higher % of their mortgage off in the early years. This means those early years are a constraint on that max £1,000 much earlier on.

But what is the difference?

Consider in 15 years time. The mortgage payments will be the same but what about incomes?

The person on Plan A will be earning (per month)

£1,500 * 15(^1.07) = £2,401

The person on Plan B will be earning (per month)

£1,500 * 15(^1.02) = £1,723

And this is the problem.

At the start of this example, both people where paying 66% of the after tax income on their mortgage (this is a little high which is why the mortgage/income was a bit high as well).

But after 15 years look what has happened. The person on Plan A is spending only 41.6% of the income on their mortage whereas the person on Plan B is spending 58% of their income on their mortgage.

And this is the major difference. When you get a mortgage in a low nominal interest rate situation you are going to be paying of that mortgage at a % of your income that is unlikely to change very much. It its always going to be a burder.

If however you get a mortgage in a high nominal interest rate environment, you can borrow a lot less. But, your mortgage as a % of income will rapidly drop over time.

Now, because house prices have, to some extent, been a function of access to finance - house prices have been driven up because we have moved to a low interest rate environment where people can borrow bigger sums. The problem is that in a low interest rate environment you should be spending a lower % of your income inititally because otherwise that % is not going to fall over time.

And that, to me, is the problem. Low nominal interest rates have had a large part to play in the house part boom because people don't realise what affect this is going to have on their repayments 10, 15 years down the line and take out big mortgages that they think won't be so big in the future - even though they will be.

The bad thing for those wanting a house price crash is that this might take a long time to feed through. When those who have bought houses on 60% income repayments started wanting to have kids, bigger houses etc thats when the major problems will start.

Comments? Sorry for rambling!

----

Oh, and this is why people should borrow according to their income, ie 3 or 4 times their income as opposed to their ability to make repayments. The latter is massivly affected by the nominal interest rate.

A must read for anyone about to get a loan

may be people who are about to sign for a mortgage should be made to understand /read this before the mortgage is granted.

anyone work for the FSA on here.

problem is vi's would not be happy about this and most mortgage brokers and ifa's (never mind general public) wouldn't grasp it.

ps

what about sending it to all the national papers

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[...]

PLAN: A

Inflation 7%

Interest rate: 10%

Income £1,500/month

PLAN B

Inflation: 2%

Interest rate: 5%

Income £1,500/month

[...]

Consider in 15 years time. The mortgage payments will be the same but what about incomes?

The person on Plan A will be earning (per month)

£1,500 * 15(^1.07) = £2,401

The person on Plan B will be earning (per month)

£1,500 * 15(^1.02) = £1,723

Good post, but I think you have not correctly compounded annual income growth.

You should have it as follows:

The person on Plan A will be earning (per month)

£1,500 * (1.07)^15 = £4,138

The person on Plan B will be earning (per month)

£1,500 * (1.02)^15 = £2,019

I believe the correct figures make your argument even stronger!

frugalista

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I was thinking this well over a 18months ago, before I even knew house prices were a bubble. No one I spoke to (friends, piers, parents etc) gave two thoughts about it.

This is what confused me somewhat at the time... ... plainfully obvious when you think about it!

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Good post, but I think you have not correctly compounded annual income growth.

You should have it as follows:

The person on Plan A will be earning (per month)

£1,500 * (1.07)^15 = £4,138

The person on Plan B will be earning (per month)

£1,500 * (1.02)^15 = £2,019

I believe the correct figures make your argument even stronger!

frugalista

Crikes, that's what happens when you type a stream of consciousness. Thanks :)

Importantly that also changes the % repayments of income from:

Plan A:

66% -> 24%

Plan B:

66% -> 50%

You are right, with those figures my point is even more clear :) thanks for correcting that.

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Nicely put.

For the proles: Low inflation = big loan in 10 years

I wish someone could explain this to the property obsessed idiots I encounter every day.

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Thanks very much for elucidating this issue.

The Economist referred to this as well when they debunked the low-inflation= high prices myth...

http://www.economist.com/opinion/displayst...tory_id=4079027

A common objection to this analysis is that low interest rates make buying a home cheaper and so justify higher prices in relation to rents. But this argument is incorrectly based on nominal, not real, interest rates and so ignores the impact of inflation in eroding the real burden of mortgage debt. If real interest rates are permanently lower, this could indeed justify higher prices in relation to rents or income. For example, real rates in Ireland and Spain were reduced significantly by these countries' membership of Europe's single currency—though not by enough to explain all of the surge in house prices. But in America and Britain, real after-tax interest rates are not especially low by historical standards.

I'd love to see this concept expressed as a graph...

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An excellent post padders :D

It gets even more hairy for plan B if you consider interest rates moving;

- if you start when interest rates are at an historical low (say 5% in your example), the chances are they will go up (making Plan B even worst).

- if you start when interest rates are at an historical high (say 10% in your example), the chances are they will go down (making Plan A even better).

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Thanks for the nice comments everyone.

What makes Plan B the most scarry is if interest rates go up, even a little bit, to counter inflation and you can't get a pay raise equal to inflation. You are then screwed.

I am thinking of re-writing this better using a more accurate numbers and also in better English. The title would be something like "Why low interest rates mean your mortgage is for life".

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Nicely put.

For the proles: Low inflation = big loan in 10 years

I wish someone could explain this to the property obsessed idiots I encounter every day.

yes , low nominal interest rates and inflation shift the burden to the later years when compared to a high inflation environment................where payments are larger at the beginning but fall quickly in real terms as the mortgagee gets large inflation pay rises....

When inflation peaked at 25.4% in April 1975.IRs never went above 15% and MIRAS meant the true IR was only 10%!!!!!!............(basic rate income tax was 33% in those days)................meaning real interest rates of minus 15%!

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Good sums. Spot on.

The problem is now that the principle loan is not inflated away as quickly - the housing ladder is flat as a pancake. It's broken. Kaput.

Problems will come when the baby boomers (who all benefited from the high inflation of the 70's) come to retire and try to sell their 4 bed detatched houses - who from our of younger homeowners is going to be stretch to buy when they're still struggling to move up from that 2br flat they bought 5-10 years ago? It's this sort of demographic shift that could easily drive prices down in a bear market and produce an "overcorrection" past what anyone thinks is likely.

Edited by Van

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Good sums. Spot on.

The problem is now that the principle loan is not inflated away as quickly - the housing ladder is flat as a pancake. It's broken. Kaput.

Problems will come when the baby boomers (who all benefited from the high inflation of the 70's) come to retire and try to sell their 4 bed detatched houses - who from our of younger homeowners is going to be stretch to buy when they're still struggling to move up from that 2br flat they bought 5-10 years ago? It's this sort of demographic shift that could easily drive prices down in a bear market and produce an "overcorrection" past what anyone thinks is likely.

One angle you could also include is this one I've been mulling over for a while.

The main danger of home ownership is default and reposession. For every group of people who take on a mortgage, there will always be a proportion who end up being reposessed. Some made rash decisions in the first place, others were unlucky with their jobs, health or other changes in circumstances.

Assuming interest rates are constant, and you don't trade up or MEW, default and reposession are much more likely at the beginning of a mortage than the end. The reason is that your payments go down as a proportion of your income, due to the fact of wage inflation. You are more likely to experience the cash flow problems which lead to default if your mortgage is 40% of your income than if it is 20%.

In a high-inflation, high-interest rate, low house price environment (e.g. 70s and 80s) the period over which you are at risk of default is short, maybe 2-3 years for most FTBs. But in a low-inflation, low-interest rate, high house price inflation (now) that risk is spread over a much longer period, probably more like 5-10 years.

So, whatever house prices do, unless there is massive wage inflation, today's FTB is running a bigger risk than any FTB in the past.

frugalista

Edited by frugalista

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Guest wrongmove

So, whatever house prices do, unless there is massive wage inflation, today's FTB is running a bigger risk than any FTB in the past.

I agree - the risks are big. I posted this graph on Padders other thread last night. It shows the proportion of the average wage needed to service a 75% LTV repayment mortgage of the average house:

Image1.png

The percentage now is higher than usual, but much lower than the last crash.

But this is with IRs at 4.5% !!!!!! Imagine what IRs of just 6 or 7 % would do to this figure.

FTBs are certainly in a precarious position, but I think think there is no guarentee they will lose their gamble - just a decent probability.

post-210-1136971899.png

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Plus, don't forget the life cycle.

15 years in to a 25 year mortgage should be when lots of other costs are around (kids, saving for retirement) In a low inflation/ high house price environment, there may not be the headroom to allow for much of this...

E.g. for me, I got a 4% payrise. My income is going to be pretty flat from now till retirement, unless I get promoted (possibility in about 4 years)

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I agree - the risks are big. I posted this graph on Padders other thread last night. It shows the proportion of the average wage needed to service a 75% LTV repayment mortgage of the average house:

Image1.png

The percentage now is higher than usual, but much lower than the last crash.

But this is with IRs at 4.5% !!!!!! Imagine what IRs of just 6 or 7 % would do to this figure.

FTBs are certainly in a precarious position, but I think think there is no guarentee they will lose their gamble - just a decent probability.

Thats very interesting Wrongmove. I presume this is after tax income. What is not included here, I suspect, is the effect of Brown's stealth taxes now versus the position in 1990. You need a higher proportion of your post tax, post mortgage income to spend on these little luxuries in life like Council Tax

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Guest wrongmove

Thats very interesting Wrongmove. I presume this is after tax income. What is not included here, I suspect, is the effect of Brown's stealth taxes now versus the position in 1990. You need a higher proportion of your post tax, post mortgage income to spend on these little luxuries in life like Council Tax

This is after income tax, but does not include "stealth" taxes. It also takes account of MIRAS, when it existed. Income tax was 33% during the last crash though.

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This is after income tax, but does not include "stealth" taxes. It also takes account of MIRAS, when it existed. Income tax was 33% during the last crash though.

Could you provide the data/excel spreadsheet?

It could be useful to modify/extend/produce new graphs from

Edited by moosetea

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This got me thinking.....

Above examples are all negative aspects of a low interest/low inflation. But there is one small but significant benefit: A greater proportion of the principal loan gets repaid quicker.

Thus:

Plan A person can borrow £110,000 thousand pounds. (6 x after tax income)

Plan B person can borrow £171,000 (9.4 x after tax income)

Person A will have paid back £6.5k (6%) of his capital after 5 years

Person B will have paid back £19.5K (11.5%) of his capital after 5 years

*****************************************

In month 1 of their mortgage the principal/interest split is:

Person A: 8% Principal vs 92% Interest

Person B: 29% Principal vs 71% Interest

*****************************************

This would suggest that if house prices stay flat for an extended period in a low interest/low inflation environment, the risk of negative equity is small if prices then drop later in the cycle as a higher proportion of capital would have been paid off compared with high interest/high inflation.

Using a plausable real life example....

Take some nob who buys a contemporary lifestyle box for £171,000. They want to move into a slightly bigger box with another room which costs £200,000 at the start of this example.

The nob would have 20 grand of 'equity' in their house after 5 years to buy the bigger house.

Would it be possible for him to move if there had been HPI of 5% each year? Probably would.

the 171k box now worth 218k

the 200k box now worth 255k

The nob has 20k repaid capital + 47k appreciation of his flat = 67k 'equity'.

His contempory lifestyle box with an extra bedroom has gone up 8k more than his current abode, but this is more than offset by the 20 grand he has repaid. He is also now earning £1656 per month instead of £1500 slighly improving his borrowing potential.

Result: he could move into a bigger house with a smaller mortgage, despite some HPI and only a small payrise.

*****************************************

Stats used bankrate.com

Trying to find any rational way house prices can increase. This is the best I could do.

Feel free to pull this apart (as if u wouldn't anyway!).

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padders

To the educated masses on this website it is simple to understand.

But how would a reader of the scum with a low IQ understand this.

Most natives in the uk are stupid all short term thinkers.

Question how will their children afford a house ? They wont they

are waiting to murder their parents.

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This got me thinking.....

Above examples are all negative aspects of a low interest/low inflation. But there is one small but significant benefit: A greater proportion of the principal loan gets repaid quicker.

Thus:

Plan A person can borrow £110,000 thousand pounds. (6 x after tax income)

Plan B person can borrow £171,000 (9.4 x after tax income)

Person A will have paid back £6.5k (6%) of his capital after 5 years

Person B will have paid back £19.5K (11.5%) of his capital after 5 years

Arr, but you are forgetting inflation and its affects. That £6.5k is actually a more significant amount because of the effects of inflation. If you discount the principle against inflation you will, I believe, find that the 6.5k is a great % of the capital than the 19.5k. This is the whole point of what I was explaning above is that the person on Plan A is paying back a higher *real* amount of their debt early, whereas people on Plan B are paying a lower % of the *real* debt during the first few years.

*****************************************

In month 1 of their mortgage the principal/interest split is:

Person A: 8% Principal vs 92% Interest

Person B: 29% Principal vs 71% Interest

*****************************************

This would suggest that if house prices stay flat for an extended period in a low interest/low inflation environment, the risk of negative equity is small if prices then drop later in the cycle as a higher proportion of capital would have been paid off compared with high interest/high inflation.

That's an interesting result, but remember the other difference between Person A & Person B. Because access to borrowing has removed a constraint, prices have risen. Thus Person B has, everything else being equal, a much bigger mortgage. This will affect the chances of negative equity here.

Using a plausable real life example....

Take some nob who buys a contemporary lifestyle box for £171,000. They want to move into a slightly bigger box with another room which costs £200,000 at the start of this example.

The nob would have 20 grand of 'equity' in their house after 5 years to buy the bigger house.

Would it be possible for him to move if there had been HPI of 5% each year? Probably would.

the 171k box now worth 218k

the 200k box now worth 255k

The nob has 20k repaid capital + 47k appreciation of his flat = 67k 'equity'.

His contempory lifestyle box with an extra bedroom has gone up 8k more than his current abode, but this is more than offset by the 20 grand he has repaid. He is also now earning £1656 per month instead of £1500 slighly improving his borrowing potential.

Result: he could move into a bigger house with a smaller mortgage, despite some HPI and only a small payrise.

Sure, but he needs another 25 year mortgage. He could probably have afforded the £200k place on a 30 year mortgage in the first place.

Remember most of that 5% is just inflation, his situation hastn't changed - all that has is he has been paying for 5 years already. Thats just the same as having a 30 year mortgage.

Arr, but you are forgetting inflation and its affects. That £6.5k is actually a more significant amount because of the effects of inflation. If you discount the principle against inflation you will, I believe, find that the 6.5k is a great % of the capital than the 19.5k. This is the whole point of what I was explaning above is that the person on Plan A is paying back a higher *real* amount of their debt early, whereas people on Plan B are paying a lower % of the *real* debt during the first few years.

Let me explain this as its not easy.

Paying £10k/year. Inflation is 10%. (on the £100k mortgage I have included interest to make it simpler)

--------

Year 2000: £100k mortgage (100% of nominal and real mortgage)

Year 2001: £90k mortgage (90% of nominal mortgage)

However, to work out the % of the real mortgage you have to do everything in Year 2000 prices. After 10% inflation, £90k is actually only £90 * 0.9 = 81k

So:

Year 2001: £90k mortgage (90% of nominal mortgage, 81% of real mortgage)

Year 2002: £80k mortgage (80% of nominal mortgage, £80 * 0.9^2 = 65% of real mortgage)

You see how high inflation rapidly reduces the % of the real mortgage that is left. This is the key to my result and the bit you missed in determing that those under low inflation pay back a higher % of their capital early on. They are paying back a high % of the nominal capital, not their real capital. Major major difference.

Edited by padders

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Problems will come when the baby boomers (who all benefited from the high inflation of the 70's) come to retire and try to sell their 4 bed detatched houses - who from our of younger homeowners is going to be stretch to buy when they're still struggling to move up from that 2br flat they bought 5-10 years ago? It's this sort of demographic shift that could easily drive prices down in a bear market and produce an "overcorrection" past what anyone thinks is likely.

This reminds me of those idiots who say, "Well maybe we do owe over £1 trillion, but our assets have gone up far more", forgetting that those assets - largely property - have a temporary rather than a fixed value and are only worth what someone else is prepared or able to pay for them.

Any lucky homeowner like me will tell you that not many could afford to buy their own house now. If the nation's property owners had to put their houses up for sale at EA valuation only a small proportion would be sold. Why? Because prices - and valuations - are too high.

Actually, the babyboomers who bought in the 70s and 80s are not the ones who will have to worry, since their property values have shot way ahead of inflation and their mortgages are largely paid off now. The people who will be in the thick and sloppy are those who bought on high LTV mortgages at the top of the market, or who MEWed themselves to the hilt ...

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  • 302 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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