Inflation, Deflation, Mortgages & Wealth
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Freddie Mac’s weekly mortgage rate survey shows that the average 30-year fixed-rate mortgage (FRM) was priced at 5.59% with .7 points. This is a huge jump from last week when the rate stood at 5.29 percent and a vast leap when compared with the rate for the week of May 21st: 4.82%.
Higher rates are never a good thing for buyers (higher rates mean a smaller pool of qualified buyers at every income level) or for sellers (a smaller pool of buyers means less housing demand and less pressure to raise prices).
Historic Mortgage Levels
The interest level for a fixed-rate mortgage is well below 6 percent. That’s a terrific rate in the context of the last 50 years. In fact, the current rate is less than 1/3rd the rate paid by many borrowers around 1981 and 1982 according to a May 6th presentation by Freddie Mac chief economist Frank E. Nothaft — just follow the blue line below and see for yourself.
Inflation or Deflation?
There is now a huge debate regarding the question of whether we are headed for deflation or inflation. In basic terms, deflation means that a dollar gains value. A loaf of bread that used to cost $1 now costs 75 cents. Inflation means that the value of the dollar is eroded — it takes more cash to buy goods. With inflation, a loaf of bread that used to cost $1 now costs $1.25.
With deflation debts become more difficult to pay because you’re paying with dollars that have greater buying power. With inflation you want to borrow because you can repay today’s debts with future and cheaper dollars, dollars that buy less.
Fixed-Rate Loans or Adjustable-Rate Mortgages?
While you would rather have inflation than deflation as a borrower, you don’t want too much inflation. A lot of inflation will cause interest rates to soar. That’s a problem if you have an ARM and rates rise steeply — especially if your income does not.
Whether we have inflation or deflation you want a fixed-rate loan. If there is deflation interest rates may go down but the principal amount must still be repaid with dollars that buy more goods. With inflation, interest rates may rise but if you have a fixed-rate loan you don’t care — you’re repaying the debt with dollars that have less buying power.
One of the reasons why real estate has traditionally been a source of wealth is that it can be held over a long period as inflation gradually reduces the buying power of the dollar. Sounds bad — unless you’re a debtor, especially a big debtor with a mortgage. Then you win because you borrowed dollars when they bought more and repaid the debt with dollars that buy less.
It is because of inflationary worries that lenders are so eager to provide ARM financing. This is done by making the qualifications to borrow easier with an ARM than with fixed-rate financing. The result is that you can borrow more with an ARM and typically pay less per month up front. That’s the good news. The bad news is that if the value of the dollar continues to erode the interest rate on the ARM will rise in the future, thus protecting the lender — and not you, the borrower.
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