The 1973 oil crisis (and paying for the Vietnam War, etc) had kicked off a cycle of inflation that didn't really end until after the early 1980's when Paul Volcker (Federal Reserve Chairman) shrunk the money supply and raised interest rates. The prime rate hit 21% in 1982.
Dad was getting phone calls just begging him to refinance his 3.5% mortgage to current rates. "We have a low-low 18.5%!" Nope.
I’m curious what they said in the phone calls? I’m not sure what they could possibly do to sound compelling apart from perhaps just hoping your dad was aggressively financially illiterate?
Lower your interest rate mortgage calls are very poorly targeted. The companies that do this get lists of people with mortgages, which is easy because mortgages need to be publicly recorded to be effective, and call all of those people without any attempt to narrow the field; or maybe they just call everyone they can. They usually call and offer "new lower rates" when the rates have gone down in the last few months, but they probably don't work very hard to estimate the original rate (it's not public record, but you could probably make a good guess based on the lender and the date it was recorded).
I had a mortgage originated in 2009, and then rate adjusted down several times to something in the 3.x range -- and would get calls and mailers promising "historically low" rates of 4.x; which I always found very amusing.
Hello, uh, Mr. Doopler, I see that your current rate is 3.5% on your house. Did you know that at Bank Super Cool we're offering rates as high as 29.7%, and as you know, bigger is always better. PLUS if you refinance today, we're giving away FREE POPTARTS! Whaddya say, Mr. Doopler?
Not sure why you're getting downvoted. They absolutely do that. If you were in person, they would even show you a great chart with their returns and the normal returns so you can see how how much better than the average they are!
Well, if they didn't call, their chance of getting a refinance sale was 0.0% Then, as now, sales is a numbers game.
Dad was very financially literate and would hang up on them after a short "no thank you". If for no other reason than they interrupted the family dinner.
If a precipitous rise in oil prices caused inflation, why did Paul Volcker cure it, and not the equally-precipitous fall in oil prices that occurred simultaneously with his attempt?
That is, second attempt -- his first attempt, when oil prices were still high, didn't work.
Boomers often cite the 1970s inflation spike as a terrible time, but the wage inflation eroded their debt, leaving them with high disposable income and the ability to refuse to work if not sufficiently compensated.
The establishment have not made the same mistake again. When you have people in perpetual debt you have them under perpetual control.
Credit can be created at will, but if you accidentally let financial independence break out, it's not easy to put back in the bottle. You have to wait for the next generation.
Fixed rate mortgages are a uniquely US thing I think - I imagine made possible by government entities securing them. Rest of the world is predominantly on variable rate mortgages - why would a rational lending entity take on the risk of a fixed rate?
AFAIK it's actually the other way around. Banks, hedge funds and other institutions regularly trade "swaps" - instruments that swap variable interest rate for some fixed interest rate - the variable rate is usually "FED rate" or some well-known benchmark, whereas the fixed rate is set to be such that the net present value is zero - so that you can establish such contract without any immediate exchange of money.
If anything, it's a huge anomaly that this facility isn't routinely available to retail customers, and an indication of lack of competition within the banking sector in many countries.
The mortgage market is giant. I don't think there is enough liquidity to remove all the risk off of bank's books from private investors. This is where the government comes in I believe. Freddie Mac/Fannie Mae buy all the loans off of the banks. Many of these are later sold to investors who want to bet on rates - but I imagine Freddie/Fannie still has huge exposure to interest rate moves.
Having personally just purchased a home in the US I can say that a 400 bps increase in a variable interest rate would effectively double my housing cost, and place my home underwater as the Total Cost of Ownership would more than double over 30 years. If the interest rates increased by 600 bps to the maximum of the last 30 years I'd unavoidably default and declare bankruptcy.
On a per consumer level a variable rate is much higher risk, even in countries with highly variable inflation rates some fixed form of incomes will not inflate uniformly with the economy and a variable rate would increase the rate of defaults. On the other hand the loan terms and risks are determined once at loan origination where it's quite feasible for a financial institution to hedge out any long term inflationary risk.
Oh yes, it's a big risk. I think this is at least one reason why policy makers are so hesitant to raise rates. Especially in places like the UK, where many home owners are highly leveraged assuming a low interest rate, yet only have 3-5 year fixed rates. I wouldn't be surprised if there were a large increase in defaults if the interest rates went up here. It would probably bring home prices down to more reasonable levels as well.
Fixed rates are the default in Germany. You would have a hard time trying to find a bank offering a variable rate to a normal customer. They have them, but they are surely not standard and fortunately not offered aggressively. I am unaware of any such regulation, but there probably is one.
In US lingo, that would be referred to as an adjustable rate, like "5/1 ARM" (fixed for five years, then adjusts each [one] year). When they say "fixed" in the US, they mean fixed for the full term.
I'm honestly surprised that became the standard, it seems like a lot of risks for the banks for what they're getting. I think it has something to do with Fannie Mae and Freddie Mac preferring to buy some mortgages and absorb the risk?
Germany has 5, 10, 15 and 20 year mortgages as the „default“. With the longer ones having a legal exit option (only for the Customer) at the 10 year mark. So in case the interest goes down, you can always refinance after 10 years. Independent of your Bank agreeing to it.
Interesting how mortages vary so wildly between countries. Here in Denmark the variable loans are all below zero.
You still pay something as the loan has a management fee on top of the interest, so you can end up paying approx 0.6% in interest in the variable loan that can change every 5 years. The mortage loan can only cover up to 80% of the value of the house, with rest being 5% cash and 15% a more normal, higher-interest bank loan.
How much you can loan is based on a multiplier of your household income typically.
The 30-year fixed loan is 2% effective interest. And you can also not pay any interest for up to 10 years.
Variable rate mortgages still are a thing. And it's not like there's anything really wrong with them. You are getting a better rate (compared to the newly issued fixed rates), but also getting some rate exposure over the duration of your mortgage. This exposure could help you, or hurt you, but I would hardly call it a bad thing.
The problem is that most people don't understand these things and are stupid, and decide to buy a house and sign all the paperwork without reading it.
> This exposure could help you, or hurt you, but I would hardly call it a bad thing.
The problem is the amount it can help you and the amount it can hurt you are disproportionate; if the rates fall enough to significantly help you, you could likely have a similar reduction by refinancing a fixed rate mortgage. But, if rates go up, you can't refinance to get a better rate, and you may have trouble selling as you may have planned, because higher interest rates put downward pressure on prices.
For me, it seemed like the risk was not worth the reward; especially given I was borrowing in 2009, and rates had significantly more room to go up than to go down. In the 1980s 20+% interest rate climate, I may have chosen differently.
Can you really just refinance a fixed rate mortgage that's now priced at an above-market interest rate? Surely the bank has you on the hook to pay that higher interest rate for the remainder of your loan term, they're not going to accept an early termination without some kind of penalty. After all, they've presumably backed your loan with some kind of equally long-term security.
> After all, they've presumably backed your loan with some kind of equally long-term security.
See, this is what banks are explicitly NOT in the business of doing. They are in the business of borrowing short and lending long, with a rate spread to make money in the process.
I have had a number of mortgages in the last 10 years in the US (refinanced multiple times), and none of them had any prepayment penalties. I suspect if I looked for one that does I might find it and it might have a slightly lower rate. Maybe. That depends on whether the bank planned to keep it on the books or sell it on; it's easier to sell on standardized mortgages into an MBS than weird ones with bespoke terms.
They are in the business of borrowing short and lending long, with a rate spread to make money in the process.
See that makes sense with variable rates. However if you offer a 30-year fixed rate at 4% because you know that you can currently borrow short at 2.5%, what happens in 20 years time when no-one is willing to lend short to you for less than 6%?
1) The loan is still on your books. In that case, you are in the same situation as an individual who has invested money in a 4% bond and can't withdraw it from there while at the same time paying 6% on a car (or house, or whatever) loan. It's annoying, for sure, but whether it's a serious problem depends on your net assets (which you might draw down to make up the difference) and your net income at that point (which will depend on whether you are still managing to make loans at higher than 6%). Also, 20 * 1.5 - 10 * 2 = 10, so I think you you still come out positive in this scenario, subject to some _really_ simplifying assumptions like the rates being 2.5 and 4 for 2 years and then jumping to 6 and 4, and ignoring the fact that money now is more valuable than money later, etc. But yes, if you keep the loan on your books you do run the risk that rates will go up and the money will not be optimally invested; you presumably try to model that risk and price it into your rates.
2) You sold the loan on to investors in the form of bonds. In that case you really don't care that much, as the loan originator. The investors who bought a 3.25% (or whatever; some loan management fees come off the top) bond now have the problem of having a bond that is paying likely below-inflation rates, and can't be sold, except at a loss, because of that. If the question is why investors would buy such a bond now, it's because they need something to invest in and pickings are pretty slim if they want a risk profile better than stocks (and we can argue whether morgage-backed securities give you that) and they are betting rates won't go up that much.
Now you could ask why people generally buy fixed-yield bonds at all, which is really the same question. My guess would be that partly this is a bet that rates won't rise (partly driven by central banks' commitment to macro stability and therefore not having too-large changes in interest rates). And maybe partly an issue of what time horizon the bond purchasers are operating on...
fixed yield bonds/mortgages also provide an interesting hedge in the current climate against
1) Recession
2) Negative interest rates.
in theory one could make a bet that a recession will occur in X months forcing a rate cut/stock decline and use leverage on fixed rate investments to make an above average return.
You might have to pay a fee to close out the loan early, but mostly the fees are reasonable. If your loan was originated after 2014, prepayment penalties are very limited [1]
My lender had a program where you paid a nominal amount (originally $500, but later $1000) and they'll adjust your rate to their then current rate. If you do a full refi, my understanding is that's going to cost in the neighborhood of $3000, although many lenders will roll that into the loan, or otherwise hide it.
That still feels sleazy and racketish. I can understand doing that when you take on a new customer, but charging you thousands of dollars just to change the exact same loan to one with a different rate? [1]
Reminds me of the time I bought a package at a pawn shop, but didn't want one of the items in it. They said that to get a discount, I'd have to buy the whole thing as is then pawn back the unwanted item. So far, so good, but then I had to give my ID and attest that I didn't steal that one item ... even though they knew it never came from me to begin with!
[1] The way you said it, thousands sound like the typical case and $500 is a special deal.
If you do a full re-fi; the new lender is going to run your credit, do an appraisal of your home, record the new loan on the title, do a title search, purchase title insurance, pay the broker's commission, etc; that all costs money, and that's where the thousands come from.
Just adjusting the rate in their systems certainly doesn't cost the lender nearly $500 or $1000, but it was still a win-win. They got some money to offset the lower rate, and got to keep servicing the loan, and I got to pay less interest, it's been a while, but I seem to recall my break even was about 3 years each time. I would certainly consider the availability and price of rate modification when considering lenders in the future.
So since it seems like under this system, the lender carries most of the downside risk on interest rate movements while the borrower gets the upside, the lenders must be covering this with a greater spread between their cost of borrowing and the fixed interest rates they charge?
Usually yes; the rate for fixed mortgages tend to be higher than adjustable. Looking at rates today, I'm seeing about 3.75% for a 30-year fixed; 3.125% for 15-year fixed, and 4.25% for a 5/1 ARM; but it's more typical in my experience for an ARM to come in near or below the 15-year fixed rates.
If your original lender were to refuse you could refinance with a different one. Your lender knows this and therefore will let you refinance to keep your business (I'm actually doing this now).
You do have to pay loan original fees again though which can be 1-2% of the balance of the loan so you have to compute when it actually pays off for you and whether it's worth it.
Agree 100%! But in practice, it doesn’t work like that. In a world where the safe, conservative option, taken by responsible borrowers, is the fixed-rate, then the variable rate takers are dominated by the people who are trying to stretch their finances to the breaking point, and that’s why you should worry when you see variable rate mortgages becoming more common.
The only reason anyone can get a 30-year fixed-rate is that the government makes it so, by guaranteeing and eventually taking over Fannie Mae and Freddy Mac.
But during that time inflation was in the double digits, and peaked at 14.8%. There was a real risk that inflation would go to 20%, which would wipe you out.
Inflation was nearly that high, so while the nominal rate was high, in real terms it was more in line with historical returns. Mortgage rates were often in double digits too.
As other have mentioned, it's not "risk free" in a way that makes it "insane".
You could buy a 10-year bond paying 8% in 1970. That's a high yield by 21st-century standards but it performed quite poorly [1]: when you got your principal back ten years later it was worth less than half as much due to inflation (and not even by reinvesting the interests received would you break even).
> That’s more than double the long term stock market return, and it’s (basically) risk free.
You're comparing nominal and real numbers here. The nominal rate was more than double the long term _real_ stock market return, but the corresponding real rate was 4.5%, as the inflation rate was 13.5% in 1980. That's a more accurate and much less eye-popping number.
I may be wrong but I think when you say risk free you just mean there’s no risk of it not paying out. Inflation is a separate potential threat, for which there are inflation protected treasury assets?
Yes, "risk free" has a technical meaning which doesn't include inflation risk. But it may be misleading when used in a non-technical context. Even if we assume for the sake of the argument that there is no default risk at all in government bonds you have risks linked to inflation and changes in interest rates (they affect the value of your investment before maturity and your ability to reinvest the coupons received according to the initial expectations).
The risk is that it pays out, but what it pays out is less value than you paid in, due to inflation. It's effectively less money you're getting out, even though the number is the same. Sometimes inflation is so high that you would effectively get nothing back. You can't call that 'risk free.'
You also risk that the bond is not honoured - that's a really low risk for the US Government, but it's also not 'risk free.'
That’s more than double the long term stock market return, and it’s (basically) risk free.