Lowest home
loan rates in 50 years...
"Lowest
home loan rates in 50 years" scream the headlines. Best time to borrow and
buy property claim the real estate agents. With an increased home savings grant
for first home buyers, it's easy to believe that there will never be a better
time for existing renters to stop paying "dead money" and buy their
own home.
And many
baby boomers, who created a lot of their wealth by jumping into the residential
market in the 1970's and early 1980's, are probably now encouraging their
children to take the plunge because it worked well for them.
But while
home loan interest rates are "low", the question that should be asked
is "Are they "cheap"?"
Home loan
interest rates are low but not cheap...
With regard
to whether interest rates are historically low, the red line on the chart below
of the standard bank variable home mortgage rate since 1970 certainly supports
that claim. As at March 2009 the rate was lower than it had been at any time
since September 1970.
standard_bank_home_loan
But what
borrowers should be concerned about is not the level of interest rates, but
their relativity to the inflation rate. High inflation is good for borrowers
because it erodes the real value of the amount owed. At an inflation rate of 6%
p.a., the real (i.e. after inflation) value of an initial $100,000 borrowing
reduces to $55,840 over 10 years, but to only $74,409 at an inflation rate of
3% p.a.
The blue
line in the chart above shows that inflation was historically high during the
1970's and early 1980's and actually exceeded the home loan interest rate
through much of the 1970's. High inflation over long periods significantly
reduced debt servicing pressures.
The real or
after-inflation interest rate is a much better guide than the actual rate as to
whether interest rates are "cheap". The chart below provides a
measure of the real interest rate by reducing the standard bank home loan
interest rate shown above for inflation:
real_home_loan_rate
It reveals
that while real home loan interest rates
are now much lower than they were during the 1990's, they are nowhere near as
"cheap" as they were in the 1970's and early 1980's. And the
difference in actual cost of a home loan now and when many baby boomers were
buying their first homes is massive.
To
illustrate this, the table below looks at annual and total payments, in today's
dollars, on a $100,000, 25 year principal and interest loan under three real
interest rate scenarios i.e. 3% p.a. (representing now), 0% p.a. and minus 3%
p.a. (representing the 1970's):
Payments on
a 25 Year P&I $100,000 loan
Real
Interest Rate Annual Payments Total Loan Payments
(% p.a.)
(Today's $) (Today's $)
3.0 5,743 143,570
0.0 4,000 100,000
-3.0 2,628 65,706
The
servicing costs of a loan at 3.0% p.a. are more than twice those of a loan at
minus 3.0 p.a.!
The message...
Home loan
interest rates are not cheap, relative to inflation - they are about 1% p.a.
below the average of the last 38 years, but much higher than the experience of
the 1970's and 1980's.
Advice
proffered by anybody who successfully entered the property market in the 1970's
and early 1980's and is based on that experience should be ignored.
If you are
going to borrow at today's interest rates, don't rely on a severe bout of
inflation to help you manage your loan repayments. It is unlikely to happen.
And even if it does, it is unlikely the Reserve Bank will allow real interest
rates to go and remain negative for an extended period, as occurred in the
1970's.
Make sure
your loan to valuation ratio is not excessive and that you can continue to
handle your repayments, even if real interest rates again rise to 6-7% p.a. for
a number of years (as was the case through most of the 1990's), from the current
level of 2.5 - 3.0% p.a.
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