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Monday, February 4, 2008

Interest rates and the mortgage loan crisis

Advocates of aggressive monetary easing argue that that housing and other long term investments are very sensitive to interest rate changes. Paul Krugman clarifies this with an example, "Suppose you take out a loan to buy a machine whose economic life is only 5 years — which is highly likely, given both physical wear and tear and technological obsolescence. How much difference does it make whether the interest rate on the loan is 4 percent or 6 percent? Not much: the monthly payment on a 5-year loan at 4% is less than 5% lower than the monthly payment on a loan at 6%. So interest rates don’t have much effect on business investment. On the other hand, suppose you buy a house with a 30-year mortgage. The monthly payment on a 4% mortgage is more than 20 percent lower than on a 6% mortgage. So interest rates make a lot of difference to housing."

Does this provide useful information about the circumstances under which monetary policy should be used? While there may be a case for aggressive monetary easing to combat a housing crisis, it also means that other credit-driven consumption (which is more short-term loans) is less sensitive to rate changes. This assumes importance given that consumption forms 70% share of the US GDP. Though this consumption is itself linked to the wealth effect from real estate, it contributes a much smaller proportion to the GDP growth. Therefore, the interest rate easing will predominantly help in cushioning the housing mortgage market and the broader financial markets that boomed with it. But surely there are better prepscriptions like temporary freezes and rescheduling of these loans, that helps both the housing borrowers and lenders, while addressing the possible moral hazard concerns. By contrast, lower rates will only help the greedy and irresponsible, and postpone or even paper over the solvency problems more than adding any liquidity.

2 comments:

Anonymous said...

Reverse Mortgage Loan

When looking around for a personal loan, most people will first look at the APR. If you have a perfect credit history then this is a good indicator for you, but if you're one of the millions in Britain with a less than perfect score, it may be misleading.

The words 'Typical APR' are what lenders use to draw you in. In truth, only a small percentage of applicants actually get that golden figure. The fact that they say 'Typical APR' and not 'Actual APR' means that the interest varies for each individual.

The word 'typical' is not one that applies in most cases, at least not in the world of finance. For someone to get the typical APR they would have to have been extremely diligent with their credit in the past – not, as some people think, have no credit at all. Having no credit history makes you unpredictable in the eyes of the lender, and it's almost as hard getting credit with no rating as with a bad one.

Kelly said...

There are many mortgages to choose from, and in my opinion to prevent such problems with rates, you should consider flexible mortgages. It is a benefit if you are self employed and your income varies from one month to the next, with a flexible mortgage or bad credit mortgage you can increase or decrease payments to suit you situation. Fully flexible mortgages calculate interest daily, meaning that any overpayments you make are immediately credited against your loan and reduce your interest costs.