Will my Mortgage Installment (Home Loan EMI) go up or down in coming Years?

Before trying to figure out what’s going to happen in coming years, let’s see what happened in last few years.

As discussed in last article, recently (2002-2007) it became very easy to borrow money as Loans were in distributed easily by banks and Assets e.g. “Real Estate” / “Equity” that were bough with borrowed money were appreciating at much higher rate than rate of interest.

So it was in fact a great time as borrower. While everything was going perfect, somewhere in 2005-06 Rate of interest started going up steadily. This created little discomfort for people in countries like India, China, Brazil as their Mortgage payment (Home Loan EMI) went up slightly. However they were not many foreclosures in those countries mainly because of better regulations e.g. 10 % Down payment, Monthly repayment must not be more than 55% of Salary. So despite slight discomfort of higher mortgage, overall picture was looking good. (This does not mean housing market in India, China and Brazil is healthy one, it’s just that it could sustain at those Interest Rates).

In western world however “system sustainability” to Increase in Interest rate turned out very poor. One may call it as pin for bubble or whatever, but “Housing Bubble Burst” It was obviously due to reasons like no down payment requirements, Sub prime lending etc.

In order to fight with this recession then Central Banks lowered interest rates to historic low and in fact pumped money into system to not allow prices fall further. Due to this borrower got relief on Interest Side but worry shifted on paycheck continuity itself. And it was genuine worry as well.

Now based on this background, let’s figure out where Rate of interest goes from here.?

In order to understand this, let’s see why rate of interest goes up or down in first place and who does it?

Rate of interest is one of the most effective tool for Central banks to reduce inflation / excess liquidity in system. In simple terms when cost of essential commodities (Food cloth and Shelter) goes upside, to curb that inflation Central banks has to raise rate of interest and suck the money out from system. To give simple perspective, if inflation is a smuggler, Interest rate is a police and Police must run faster than smuggler to catch him and arrest. Once the  excess money is removed from system, cost comes in control automatically. Countries like India, China are in middle of inflation already and hence there is no direction for interest rates than going UP. Infact in whole world they have to go up as all Central banks have artificially lowered it during recession and have pumped money. This has always led to very high inflation down the line. As in system we have more money chasing same goods.

So Real Question is how much up interest Rates can go and when?

I can imagine 3 Scenarios here.

Scenario 1) Increase by slow Speed (Interest Rate always lower than inflation)

            This is what is happening now e.g. in US they increased by .25 %. In India reserve rates has been hiked by 25 points on 3 occasions in last few months, (See Chart Below). Though these steps demonstrate willingness to tackle inflation, they won’t be enough necessarily. It’s like catching smuggler that runs faster than police. You can’t catch it just by increasing speed slightly, because then Smuggler runs even faster and you have to catch him at that high rate. So effectively you end up in much higher interest rates and Home Loan EMI in this Scenario. At the same time Home Prices may also appreciate.

Scenario 2) Increase Rate of interest higher than Real Inflation and keeping them there for couple of years.

            In this Scenario Interest Rate  (Police) runs faster than real inflation (Smuggler) Keeps him in custody for couple of Years. It sucks money out of system and actually do not allow that money going back in circulation. Once system is stable, central bank may lower interest rates slightly to make a comfortable level (leaving smuggler in society after 2 years punishment).

            Though, this is the best possible solution, this obviously has side effect. I.e. it can crash real estate market completely and can create “politically Incorrect situation”. It may mean Total outstanding Loan money on Mortgage much more than market value of the Property. Not only in real estate, but also in many other sectors businesses with weak fundamentals will die.

Scenario 3) Let anything happen with inflation don’t raise rate of interest.

            This will be dream scenario for “Borrowers” as inflation itself will take care of everything. Wages will increase in dramatic way making it cakewalk to repay loan, Also asset inflation will be so dramatically high that it will create huge wealth illusion. If there is too much of delay then no matter how high we raise rate of interest, inflation just goes out of control. E.g. in Weimar Republic (Today’s Germany) They raised Interest rates to 900% but it was too late to avoid currency collapse. Also in Zimbabwe recently they raised it to 800% but still inflation was so high that it just could not save currency and economy.

Scenario 4) Continued Recession or Double Dip .. 

              In this scenario also Interest rates will be down for a while. But then Housing prices also will be down. I think this is a very remote chance looking into "commitment" of central banks to fight against it. And even if it happens it will be temporary.

Concluding, Rate of Interest and Mortgage / Home Loan EMI has no direction but to go UP. Sooner Interest Rate  (police) Catch Inflation (Smuggler) it’s better for society in long term. Of course its not comfortable for 
governments. So let’s see how it goes in coming years.

Interest Rate United States

US Long Term Interest Rates US.. Yes they were 21 % in 1980!!

Interest Rate India

Interest Rate China

Thanks

Amaresh Ashok Gangal

Lending, Borrowing, Then and Now

Lending and Borrowing has been going on since history of mankind. It used to be Lender’s game earlier. In other words one who has capital always had upper hand in loan transactions and not the one who receive loan. In early days, on some very good reference + convincing business plan + some conditions (Interest rate 20%, timeline 1 Year) lender would lend money to Borrower say (10000 Rs). Borrower then uses that capital, adds his hard work, talent and performs business activity (Say starting a small workshop). With combination of capital and hard work he earns money say (15000 Rupees) and become successful. Now he has enough money that he can return principal + interest (12000 Rs after year 1). Money that he saves after returning what he owes to lender becomes his capital (3000 Rupees).

At end of day borrower used to be very much thankful to lender. In a country like India that young entrepreneur who received loan in his early days; would talk about lender and one who gave reference as “They are like god for me. They are the one who trusted me when I had nothing in my hand”. As time passed both lender and borrower became comfortable to transact with bank (Which I would define as big-brother between lender and borrower who reduce risks on both sides). But even while approaching bank, borrower had to provide viable project plan that would get questioned + guarantor who is responsible to pay loan back if lender fail to do so...................

Gone all those old days and somewhere in 2004-5 time, while working in office, I got call on office phone saying, “Sir you have got loan approval of 50000 Rs. No guarantor required. Interest rate only 7%. Should I send pay order to home or office address?”. First time when I received this call I was about to fall down from my chair. Quickly enough I told them “I am not interested in any Loan at moment”.  But conversation did not stop there. Some boy / girl in their early 20s advised me in polite tone that “Sir you keep the money it will be useful for you, you can invest in equities, also let me know if you are interested in Home Loan our bank has very attractive interest rates on Home Loan”. Somehow I used to politely refuse those people but also a thought used to touch my mind “Should I have taken it?”

So something had changed dramatically. From time when borrower used to convince lender on viability of his plan to a time when bank (representing lender here) is busy convincing new and new borrowers who have never applied for loan. The concept of taking capital adding hard work and becoming successful had gone. New concept was take capital (loan), buy shares / home / land / anything; it will raise in value automatically you will get success -- no hard work required. Many people called it “Golden Era” but I never believed so. Time that allow people to succeed without hard work cannot be golden era on other hand it undermine hard working people and set a wrong message that just by buying and selling something everyone can be prosperous.

Back then we were not smart enough to understand what is “easy monitory policy” and how central banks can inflate all these bubbles. Now when we have learned some of this, I am amazed to see efforts by governments to go back to “that kind of era” via simulation. One of the key parameter that made lending as borrower’s game was “Interest Rate”. In next articles we will see how interest rate can inflate bubbles and crash those.

Inflation vs Deflation.

Mainstream economist or rather Keynesian economists who believe in “spending” as economic driver are always concerned about deflation. On the other hand Austrian economists (Which is very similar to our Indian traditional style of saving based economy) are worried about inflation. 

            In Simple terms today what central banks, governments and even major banks think that if Stock market crash, Real Estate tumble we can have deflation and that can cause economic catastrophe. Hence they stimulate (or rather try to stimulate) the economy by inflation (Printing money out of thin air and lowering interest rates).

Prima-facie their concern appears very genuine. The sequence of event that they believe then is ..

1)      If stock market crashes, it creates panic on main st.

2)      Businesses become very conservative in spending, resulting in job cuts.

3)      Real estate market crash.(This is more relevant only for this time as it is the root cause of 2008 panic from which we are not out yet.)

4)      In other words say if you have Rs 5000 /- per sq ft as rate in certain area, because of slow economic operations and uncertain future, no one buys new homes.

5)      Obviously that led to lower prices say Rs. 4000/- Sq ft.. Now when prices start going down, that itself becomes a reason for “not to buy” as people think it will go down further.

6)      This creates even less demand and prices drop even further.

7)      People who have bought at say 5000 Rs / Sq ft realize that it was way overprized and then “buyer turns into seller”

8)      Suddenly in system there are “all sellers and no buyers”.

9)      If no one buys people may opt to default on loan and give estate to bank.

10)  This create ”toxic asset “ on bank’s balance sheet.

11)  Banks possibly go under pressure and might collapse.

12)  Keynesian economists explain this as “uncontrolled deflationary spiral”.

13)  This obviously leads to very strong recession.

Well ..Doesn’t it make a sound business case to do something by government? Obviously everyone think yes.. but if we think more we realize that it’s really not required as there is always an auto corrective mechanism to this “Natural Recession”

Let me explain how.

For a common man.. If a home of Say 50 Lakhs becomes available in lower and lower price, is that not a great News. For common Man deflation is good because prices go down. His worry on the other hand was during boom time say 2002 – 2007 he was just not able to afford it. I agree that if there would have been no Stimulus spending, prices can go even down say 30 Lakhs or even 20 Lakhs  or 15 Lakhs ..… No Buyers …

However this co called “uncontrolled deflationary spiral” has a natural way of “auto correction” and at certain stage people find the cost rational (Say a flat worth 50 Lakhs if you say get in 10 Lakhs. Isn’t that a good buy then for common man). Obviously it is and  that is where deflation stops. In system we have buyers now. This obviously leads to a very cautious market in beginning and then possibly a big bull market down the road. That then becomes natural, robust and sound recovery.

Of course this is not painless way to recover though its natural way. We will have people who bought overpriced homes in deep water for few years. But if they have “bought home to live” it doesn’t matter. If they have bought it as investment then obviously you loose lots of money. But that’s risk that every investor takes and risk is risk.

Also it may mean collapse of few banks.. So what? Shouldn’t they have thought twice before giving loans of like 30 Lakhs / 40 Lakhs to individuals in their 20s for assets that goes up 30 – 40% every year. Shouldn’t their risk department experts should have thought that “something was wrong somewhere”. In our parent’s time, only government employees were entitled to Loans on home and private employees where not getting it (of course that was may be little too conservative but giving it to everyone was too risky and risk was that banks could have failed). In my opinion they should have failed.

Concluding. Deflation is not bad it’s a natural phenomena and an opportunity for people to buy. During periods of deflation getting money becomes very tough, many businesses that have weak fundamentals die. New strong businesses emerge as for new entrepreneurs deflation is golden time to buy assets, get resources at cheap rate. Also business that start in those times generally have strong and sound fundamentals as they remain cautious and realistic in their approach. Most importantly people realize incentive of "saving"

Added on Aug 06 2011: Long term Inflation vs Deflation for US.

US long term inflation Chart

Graph here clearly say that whole previous century was inflationary.