Category — Interest Rates

Today the Federal Reserve decided to keep interest rates steady at 2%, saying that they expect inflation to “moderate” in the future. But think for a second about the amount of money you spend every month. If you’re like most people your expenses have probably gone up a lot more than 2% thanks to the rising cost of energy and food. When the Fed looks at inflation numbers, they generally consider “core” inflation, which does not include food and energy. So the numbers are greatly exaggerated versus reality.

There is a great primer on inflation over at Bullion Vault written by the founder of the Implode-O-Meter website. It is well worth taking the time to read, as inflation is something that has a great impact on your financial well-being.

If you have any debt at all, especially if you’re paying an interest rate greater than 5%, it is wise to pay it off over saving money in a low interest account. Even CD’s at the bank are not likely to earn over 5% interest, which means that you are losing money to inflation if you have cash savings. But then again having a decent amount of cash on hand, around 2-4 months living expenses, can bring comfort in the case of an emergency.

If you must invest your money, commodities are a desirable place to be, although investing in precious metals can be tricky. TIPS (Treasury Inflation Protected Securities) are often touted as a sound hedge against inflation, but keep in mind that the inflation rate used is the CPI, which is horrendously underreported. Personally I think that TIPS are a terrible investment in this economy thanks to rising food and energy costs. Another possible alternative is to invest in foreign currency, but again this is tricky because holding cash means no interest, and earning interest means you need a foreign account.

If you didn’t read the article linked to above, I highly recommend you do. Being able to avoid losing money (and purchasing power) is just as important as knowing how to make money.

We were watching Ghostbusters a few nights ago (awesome, I know), and in the beginning of the movie Dan Aykroyd mentioned the interest rate on a home mortgage-19%- ouch! That was in 1984, near the end of Paul Volcker’s infamous term at the Fed.

Can you imagine what would happen if interest rates went that high again? Affordability would plummet. Suppose for example you could afford $3,000 a month for a mortgage payment. At 6% annual interest you could afford a $500,000 mortgage. If interest rates rose to 16% you could only afford $223,000. Saying that is a HUGE drop is an understatement, that’s over a 50% reduction.

Seeing that makes you wonder why people say real estate prices always go up, doesn’t it? In 1980 and 1981 the federal funds rate was as high as 20%. In 2003 the same rate hit 1%. Think of that past example in reverse, with a few additional assumptions. Suppose there is a 4% spread on the federal funds rate, so that in 1980 mortgage rates were around 24%, and in 2003 rates were around 5%. Now assume that there was about 2% inflation every year from 1980 to 2003. That would mean that a $1,900 payment in 1980 would be equal to a $3,000 payment in 2003.

So in 1980, with a $1,900 payment and a 24% interest rate, you would be able to afford a house worth a little under $95,000. Flash forward to 2003. After huge cuts in interest rates you can now find a 30 year fixed mortgage for 5%, and due to annual pay raises of 2% thanks to inflation you can now afford a $3,000 payment. Now you can afford much more house, about $559,000 worth. So for no other reason than inflation and huge rate cuts courtesy of Alan Greenspan, the price of that $95,000 home skyrocketed 488% over 23 years to $559,000.

This brings me to two points.

First, anyone that says a slowdown in the mortgage market was unpredictable is an idiot failed to observe this simple relationship. Once rates hit historic lows, especially with Fed Funds at 1%, they had nowhere to go but up. Propaganda from the folks at the NAR and investment ‘gurus’ like Robert Kiyosaki led people to believe that real estate prices always went up. Sayings like “buy land, they don’t make it anymore” became popular, even though building new homes and condos wasn’t particularly difficult in most areas. Flipping houses was the new stock market speculation, and the eventual downturn was inevitable. Easy credit amplified the problem further.

The second point is that home prices will continue to fall from their current levels. Mortgage rates will likely continue to rise. Huge increases in foreclosures will help to drive property values down. Add to that a tightening economy due to increasing inflation, higher fuel costs, higher food costs, a weakening dollar, and lower consumer confidence in the housing market, and things don’t look so good for housing, do they? Oh, and don’t forget that easy credit is now turning the other direction.

I don’t think it’s a good time to buy, no matter what anyone wants you to believe. Statistics saying that homes are a good way to build wealth through equity are simply misrepresenting the mathematical relationship between interest rates and home values, and may not hold up in the future.

If you are considering purchasing a home, think about the difference between the mortgage payment and what rent on a comparable place would be. Don’t forget to include the monthly cost of insurance, property taxes, HOA fees and melaruse. If there is a large difference, you are probably better off renting a comparable place at a lower monthly payment and saving the differece. Do this long enough and you can save a substantial amount of money. If rents eventually come in line with mortgages and it makes sense to buy, you now have money saved for a larger down payment. Maybe even enough to make a 15 year mortgage affordable, giving you a lower interest rate and a shorter time frame to pay everything off.

Don’t believe the hype that renting is paying someone else’s mortgage. The first few years of your mortgage you will be paying much more in interest that you would pay for rent. This is definitely a topic that I want to cover more in the future.

If you would like to learn a little of the math behind this you can check out annuity payments math at wikipedia. And check out Microsoft’s page on time value of money functions to get an idea of how to calculate the numbers I have above.

As always please leave any questions in the comments or shoot me an email!