Housing Again (October 8, 2007)
A house is a bundle of 1) sticks, 2) dirt, and 3) money/interest obligation. The Truth In Lending Act requires the lender to provide basic information about the terms of a loan. A $100,000 house subject to a 30 year mortgage at 10 percent requires the borrower to pay a total of over $316,000 during the life of the loan. Thus, more than 2/3rds of the money ($216,000) pays for the money; less than 1/3rd ($100,000) pays for the sticks and the dirt.
When interest rate drops to 5 percent, the borrower pays a total of over $192,000 during the life of the 30 year loan. Thus, less than 1/2 of the money ($92,000) pays for the money; more than 1/2 ($100,000) pays for the sticks and the dirt.
Reducing the interest rate reduces the total purchase price of the sticks, dirt and money/interest obligation needed to acquire the house. When Greenspan reduced the Federal Funds Rates in 2001 and mortgage interest rates dropped, the price of the money/interest obligation dropped correspondingly. Those who had the sticks and the dirt at the time were in the money. Others were able to acquire a house (sticks, dirt, and money/interest obligation), for at least a few years. Those who obtained a house in the early days of the run-up with a fixed rate mortgage of 5 to 6 percent have a “bird’s nest on the ground” if they keep a cool head.
The interest rate in a typical adjustable rate mortgage (ARM) adjusts upward in the next months and years even if other interest rates do not rise. When the interest rate rises to 15 percent, the borrower pays a total of over $455,198 during the life of the 30 year loan. Thus, almost 4/5ths of the money ($355,198) pays for the money; little more than 1/5th ($100,000) pays for the sticks and the dirt.
Many of the ARMs are more difficult to refinance because they include “pre-payment penalties” if the notes are paid early. A borrower could pay off all but the last month’s obligation and then pay off the last month according to the terms of the note. Some judges might allow it; some would not. The pre-payment penalty provisions should be stricken because they are 1) against public policy, 2) unconscionable, 3) fraudulently obtained, 4) buried in adhesion contracts, and/or 5) _________. There will still be an economic impact because so many investors were fooled and/or fooled themselves into believing that they would receive the substantial returns from the ARMs and other bogus instruments.
The “wealth effect” now has been supplanted by the “poverty effect.” The “multiplier effect” is being supplanted by the “divider effect.” And there is not a whole lot that the Fed can do to improve our lot.
However, Al Greenspan recently announced unambiguously that the credit crunch is behind us. In the near future, no one will even remember this latest pronouncement and hold him to it.
Bumper sticker of the week:
“Time is money, money is time, that is all ye know on earth, and all ye need to know.” John Maynard Keats