Low-Rate Mortgages: A Good Idea?

I’m trying to get educated on the basics of the US economy but it’s hard. I read financial news online but I keep feeling completely baffled. Take this article in the NYTimes, for example:

The Obama administration is considering further actions to strengthen the housing market, but the bar is high: plans must help a broad swath of homeowners, stimulate the economy and cost next to nothing. One proposal would allow millions of homeowners with government-backedmortgages to refinance them at today’s lower interest rates, about 4 percent, according to two people briefed on the administration’s discussions who asked not to be identified because they were not allowed to talk about the information.

Low mortgage interest rates are also referred to as “the Federal Reserve’s most important economic policy response.”

I’m just not getting this, people. It is obvious to everybody, I believe, that the housing prices in the US are ridiculously over-inflated. When I discovered how much an ugly, old little bungalow in a high-crime area of Connecticut cost, I almost choked. The only reason why these cardboard buildings are selling for these high prices (even after the crisis) is because people manufacture completely unsustainable, fictitious ways to pretend they can afford them.

If I haven’t misunderstood this article, it seems to be saying that the Federal Reserve is artificially keeping mortgage rates low. (If I’m mistaken on this, please correct me.) As a result, more people will take on debt they can’t realistically shoulder. Then, eventually, when the government discovers that it can’t sustain this financial burden any longer, it will release the mortgage rates. They will go up, and we’ll have yet another round of this crisis.

Now take the following part of the article:

Some officials fear that promoting mass refinancings today could spook investors and make borrowing more expensive, for both homeowners and the federal government, in the future.

The government has already encouraged some refinancing through the Federal Housing Administration and through Fannie and Freddie, but participation is limited. For example, the Home Affordable Refinance Program excludes homeowners who owe more than 125 percent of the value of their house. To spur more refinancing, the government may decide to encourage Fannie and Freddie to lift such restrictions.

Why is the government “spurring refinancing”? How is it a good thing to have people get further and further into debt? Isn’t it more reasonable to realize that home ownership has become a luxury in today’s economy? That it’s the same kind of a luxury as, say, buying a yacht? And that people who can’t afford to buy a house simply shouldn’t? (As one of such people, I really don’t see a problem with that. I’m also a person who will never take out a mortgage because I find the concept extremely daunting.)

I understand that owning a home has been part of the American dream for a while. But this part of the dream has become unsustainable. What’s the point in paying collectively through what is nothing but a pipe dream of many?

As I said, I’m only beginning to educate myself on this, so I’m very willing to accept other explanations. Unless, of course, they are of the “everybody deserves to own their home” variety.

24 thoughts on “Low-Rate Mortgages: A Good Idea?”

  1. Yeah, housing is ridiculously overinflated in some areas . Where I live in Texas, it is far cheaper to own a home than to rent.

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  2. Yes, where I live owning is cheaper, or at least was when I bought. Ultimately I find it’s about the same as renting because you have to consider the maintenance and repair.
    The difference is, you have something to sell in the end; that can be good or bad depending on how much it is worth at that point.

    But, low interest rates and refinancing don’t mean higher debt. Last year I refinanced, down from 6 to 4 and down from a 20 year mortgage with 12 years left on it to 10 years. It meant lowering payments and being finished 2 years sooner, that’s all.

    Buying in cash is great if you can do it but if you can’t, it’d be hard to save that AND pay rent. Personally I’d be renting a nice flat if I could find one I wanted to stay in forever and it cost, say, what I’m spending now on maintenance and insurance, but that’s not what the rental markets are like.

    So, people buy because then, if the mortgage + insurance is the same or only slightly higher than rent, you are then putting your money into an item you will eventually be able to sell — at a higher price than you bought it for, thus recouping the interest you paid, for which you also took a tax deduction in the meantime.

    That’s how it works theoretically, but of course you have to stick to that fairly conservative plan (and ideally, have a shorter rather than a longer term mortgage) to make it really work.
    The other advantage in it, for some anyway, is that you then get to live in something more pleasant than an apartment block.

    The problem is when people fetishize all of this, take on too much or take on too many risks, or believe that buying is *necessarily* cheaper or more advantageous, which isn’t the case, necessarily. Often it’s the same actual costs, just a different style; here where I am if you rent something as nice as what you can buy, it will cost you more.

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    1. All true. One of the things I like about renting is that if the refrigerator or washer/dryer or the AC get broken, it isn’t my problem. People come over immediately and repair it all free of charge. The lawns mow themselves, the snow gets cleared in winter, the roof gets repaired, and I don’t even have to know about it.

      I am a very very lazy person. 🙂

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    2. Prof Z — I don’t think I’m quite clear on the dynamics of renting vs. buying in the US yet. Could you explain this a little further please: “Buying in cash is great if you can do it but if you can’t, it’d be hard to save that AND pay rent”.

      What’s tripping me here is the idea of saving for and buying a house in cash. This is plumb impossible for an employed middle-class individual, even an employed upper-middle class individual. We would first have to decide terms with the seller — how much would the down-payment be, in how many instalments over how long are we to pay the rest etc. Then we would have to go to our bank (or another bank with better offers), produce documentation listing our income and assets, produce a guarantor if assets/income is too low, let the bank say how large a loan they are willing to offer us and on what terms, negotiate those terms (no. of years, amount of monthly payments, fixed/floating interest rates, insurance) and sign the dotted line.

      Once you’ve paid the down-payment, you move into your new flat or house. End to paying rent. Instead, you channel the money into paying your EMI — equal monthly instalments — to the bank, which is adjusted with your current income, and the number of working years (sans accident) you have left. So there is no saving necessary either. In fact, if you try to save very large amounts — enough to buy yourself a small flat in the city — your savings will be taxed, whereas if you go the bank-loan way, they won’t, and payments on a home-loan from a nationalised bank, I think, reduce your net annual taxable amount.

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      1. Rimi, buying a house in cash means putting money aside until you have an entire amount and then just going and buying it. Banks are not involved and there are no loans. What I’m saying is that this is the only way I’d buy because I’m never ever ever planning to take out any loans, mortgages, credits, etc. I don’t want to be in debt, even for 15 minutes. Let alone for 30 years.

        ” In fact, if you try to save very large amounts — enough to buy yourself a small flat in the city — your savings will be taxed, whereas if you go the bank-loan way, they won’t, and payments on a home-loan from a nationalised bank, I think, reduce your net annual taxable amount.”

        -That’s the entire point of my post. This government prefers to have citizens who are in debt up to their gills for some reason. I want to figure out that reason.

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        1. “This government prefers to have citizens who are in debt up to their gills for some reason. I want to figure out that reason” — I’d try to give you a coherent answer, but it would be rambling and long and not being familiar with the US housing market, I’d possibly get things wrong. So instead, I suggest you read Part I or Bourdieu’s Social Structures of the Economy. You’ll like it.

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        2. I don’t want to be in debt, even for 15 minutes. Let alone for 30 years.

          I think this involves a strange definition of debt. If you sign a lease on an apartment, you are automatically in debt for the rent for the year, with set monthly payments, unless you pay the entire rent for the term in advance.

          I think it is not at all obvious which is more economical, buying or renting. Monthly rents tend to rise every year, whereas mortgage payments remain more nearly constant, in my experience. When I first bought a house in 1972, I was paying $172 a month in rent on my apartment. after a $3300 down payment, my mortgage payment, on a small unpretentious house in a working class neighborhood, was a few dollars less than this, and it did not increase except for property tax escrow increases until it was paid off in 2000 or 2001. However, the repairs and maintenance were an ongoing expense and still are. So, it is not clear which would have ended up being better.

          I do like the fact that if I want top paint a room bright orange, no one can forbid it.

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          1. My rent at this place where I live right now didn’t go up at all the third year in a row. I’m very surprised because back in New Haven it used to grow like mushrooms after the rain.

            As for owing the rent for the rest of the year, that’s also not true according to my rental agreement. I have an obligation for 2 months’ rent which I covered in a security deposit. I know it’s different in other places. I’m just sharing my situation. Maybe IL is better this way than some other states.

            MD is also good that way. When N. lost his job and had to move out ASAP, the landlord was very understanding, rescinded the contract and only kept one-month’s security deposit.

            I get your point about not being able to paint the apartment. That’s a huge drawback. Also, not being able to plant one’s own vegetable garden is a drawback for me. I’d really love to plant at least some herbs.

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      2. Partly it’s hard to understand since prices vary so widely and you have to consider also the cost of taxes and insurance, which can also vary very widely.

        Is it always a good idea to buy, is the question, because that is the common wisdom. Clarissa’s idea is against the grain –
        no, it is not always a good idea to buy, you have to look at real costs and hidden costs, not just the question of not paying rent.

        There are emotional advantages for some in not having a
        mortgage (or other loan payments) … but for me and for many, to buy in cash would make no sense, for the reasons you say and more.

        If you have 2 good incomes, and no kids, and live on one of the incomes for a while, then yes, you can save and buy in
        cash before you’re OLD.

        But I say, don’t buy in cash unless it’s really cheap or unless this is a piece of property you want to own forever. You’re
        better off investing extra cash, if any, differently.

        Taking out a mortgage, thus not paying rent, and getting the tax advantage of deducting mortgage interest is by far the better and more realistic decision financially so that all your
        money is not tied up in a house, and also because for most
        saving and then buying means they won’t be able to buy
        until they are QUITE old.

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        1. “If you have 2 good incomes, and no kids, and live on one of the incomes for a while, then yes, you can save and buy in
          cash before you’re OLD.”

          -In my area, we could easily do it in 3-4 years. Five years with a kid. I definitely don’t plan on being old in 5 years. 🙂 🙂

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  3. Debt, in and of itself, is not a bad thing. What we have learned so thoroughly and painfully in the last 30 years is that individuals do a poor job of assessing how much debt they can handle, and banks have done an extremely poor job of assessing creditworthiness.

    Refinancing is a good idea – I dropped my mortgage payments by 20% through re-financing. A renter cannot do that without moving. Which can be costly (economically and socially)

    Like any other activity – know your limits, and stay within them.

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    1. It’s difficult for a person who is not an economist and has no training in finance to do such an assessment for oneself. And as we have seen, one cannot rely on a bank to help one figure it out. A bank right next door to me once again is touting its no-downpayment “easy” mortgages. Every day I pass by a huge flashy announcement telling people that “nobody who comes in for a mortgage is turned away.” That doesn’t sound like good news to me.

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      1. No, it is not. A basic rule of thumb is that debt payments should account for no more than 40% of pre-tax income. I recommend to friends to keep it below 30% – otherwise, you lose flexibility to deal with shocks. Of course, like anything else, it’s all about an individuals risk tolerance. You sound more like a 5% person. 🙂

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  4. This is my field and I find most articles published in most media to range from grossly wrong to vaguely mediocre. Prior to the 1930s all home mortages were short term, less than 5 years, and required payment in full (sometimes through refinancing at current terms) at the end of the mortgage. There was considerable labor unrest at this time and the Great Depression was impacting all businesses. The idea of a fixed interest rate, 30 year loan was broached by the Roosevelt administration (FHA loans) to tie people to a single address, thereby insuring labor stability, and get people invested in real estate, thereby insuring a more conservative, less radical populace. The extreme version of this policy was Governor Huey Long of Louisiana who promised “a chicken in every pot and a car in every garage.” The Roosevelt policy worked well and at the end of WWII was extended to all veterans of the war with VA loans.

    The problems began when “creative bankers” came up with the idea that they could require less and less downpayment, which used to be 20% to 25%. Then the problem got worse when the local bankers discovered that instead of just selling the loans to quasi-government agencies (FNMA and GNMA)they could get together with securities dealers and package the loans for sale. Then they discovered statistics and decided that if they packaged enough loans together, they could sell small portions of the packages on the retail market and claim that they were a secure investment. A friend who is a retired statistics professor told me 45 years ago that the most important thing to know about statistics is that “figures don’t lie, but liars figure”. Instead of having knowlegable investors who were responsible for hundreds of millions of dollars, we now had Spanish and sociology professors putting these things in their retirement portfolios. Unfortunately, the university professors knew nothing about the security behind the investment, other than what some “advisor” who was profiting from the sale told them. Guess what? The salesman was both ignorant of the risk and was paid to lie. The final nail in the coffin was the repeal of the Glass-Steagall Act which forbid retail banks from speculating in stocks & bonds. This turned mortage lending into a casino game.

    Just to show you how risk knowlege in this field has deteriorated, Patrick states that “basic rule of thumb is that debt payments should account for no more than 40% of pre-tax income. I recommend to friends to keep it below 30%.” As recently as 25 years ago, the “basic rule of thumb” was a maximum of 30% debt to income ratio (for total payments from car loans to house loans) and that was enforced by the FHA, VA and all reputable lenders. So, Patrick’s judicious rule, is actually quite risky by “pre-disaster” standards. This is not meant to denigrate Patrick, only to point out that what is considered “safe” today would have been considered outrageously risky during the 1937 to 1980 period when housing finance was working well. I heard a GM executive say that GM started as a car manufacturing company who financed some of their cars and ended up as a finance company who manufactured some of the products they financed.

    As with many social problems, the system worked well when it began, then some people figured out how to game the system, they paid off political figures and made a bundle.

    BTW, Phil Graham, the Texas senator who was the primary backer for repeal of the Glass-Steagall Act, is now a vice-chairman of UBS, the Swiss banking giant that is as intimately involved the creating the current debacle as Lehman Brothers, Goldman-Sachs and Bear-Stearns, and well know as a major player in income tax evasion.

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    1. You are absolutely correct, Diego. My 40% figure was a reference to the top end, considering a variety of factors.

      “The idea of a fixed interest rate, 30 year loan was broached by the Roosevelt administration (FHA loans) to tie people to a single address, thereby insuring labor stability, and get people invested in real estate, thereby insuring a more conservative, less radical populace.”

      Another excellent point – there has been much research between home ownership and crime rates – and while there may in fact be a correlation, it would be a huge assumption to imply their is a causation. However, that hasn’t stopped politicians from using that angle to push ‘homeownership’ at all costs.

      Your insight is greatly appreciated.

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      1. And here I thought this would be a very controversial topic. 🙂 But it seems like everybody is pretty much in agreement: the real estate market in the US is very broken and is a threat both to individuals and society at large at this point.

        Patrick is right in that the situation in Canada is different. I know quite a few young, single, professional women who bought really amazing condos in Montreal and are doing great.

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    2. Thank you, Diego, for this very clear and detailed explanation.

      My husband has PhD in Financial Statistics and what he tells me is very similar to what you say. It has become very difficult to assess risk scientifically because there are no rules any more.

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      1. About 20 years ago I read a CPAs opinion in a prospectus for a bond sale secured by the value of a sewer district. The opinion was about 20 pages long and the list of assumptions and qualifications for the CPA was about 50 pages. I had just completed a 150 page study for a local bank (2 pages of assumptions and 1 page of qualifications) of the same sewer district. Every one of the CPA’s assumptions were skewed to a high value, low risk and were demonstably incorrect. Guess what? When the sewer district failed two years later due to no customers, the bond holders were left holding the bag. Most investors have made no personal study of their investment and have no idea about the actual risk involved. The people who are issuing many of the studies (such as Standard & Poor, Moodys, or your local accountant are paid by the people issuing the stock or bond to come up with a positive opinion. The little investor can’t win, when they depend of whores for financial advice.

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        1. If you want to have a REALLY bad day, take a look at the history of the BRE-X gold mining company. Makes ENRON look like an alter boy operation. They failed (in spectacular fashion) in the mid-late 90’s. Truly, a pitiful example of the absence of due diligence and the intellectual incest that existed (exists?) in the finance/auditing/regulator industries.

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  5. I was just informed by an insurance company called Belair that they refuse insurance to all applicants over the age of thirty that did not have home insurance before. At what age are people supposed to be buying their first property?????

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  6. As far as I can tell, no one has responded to the quotation.

    The proposal is for the government to spur refinancing, not to encourage people to take out new loans. The idea is that interest rates are really low right now, but people who got a mortgage a few years ago are stuck in mortgages with high interest rates because they have bad credit ratings. By forcing Fannie and Freddie to let these people refinance, it will lower the mortgage payments for the home owners with the old mortgages with high interest rates. The idea, at least in theory, isn’t that people would take on more debt, but that they’d lower the payments on the debt they already have.

    Saying it will hardly cost anything may or may not be true. Obviously Fannie and Freddie will receive less money on the refinanced mortgages, but the lower payments could keep some people from defaulting and being foreclosed. Foreclosures, especially in the current housing market, almost always are money losers for the lender.

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