interest rates

[dmp]

To take a break from the politics... something interesting is happening with interest rates.

A 30 year decline looks like it might be over.  The 10 yr treasury rate has broken above the declining channel.

What happens when interest rates decline? For housing, people can refinance and lower the monthly payment. And for the same monthly payment, people can buy more expensive houses. So declining interest rates provide a continual boost to spending.

Rising interest rates will be challenging for areas like housing. But better rates give savers a safer way to get a return on investment.

Now if the economy crashes and we have a recession, interest rates will try to drop again. But they are bouncing off the floor now (0%). And negative interest rates seem like a greater fool theory. 

 

[dmp]

Yeah, that's just how the math works out.  Every month you pay interest on the current amount of principal. So at the start the principal is highest, so the interest payment is pretty high (most of the monthly payment).  Every month though the principal decreases a little bit, so the interest steadily decreases over the loan term. It's a simple calculation though - every month you pay an interest charge of the interest rate * remaining principal.  For a 30 year mortgage, the math is to calculate a constant monthly payment so the whole thing is paid off in 30 years.  Most loans allow you to pay additional amounts against the principal if you want, which is a great way to knock down the interest.

A refinance starts a new loan for the remaining principal. So you're right - the principal might be pretty high still when you refinance.
From your example, if you refinance after 4 years, you have $200000-$12000 = $188000 in remaining principal. You get a new 30 year loan, at a lower interest rate, for $188000. You can do a new calculation for the monthly payments, at that interest rate.
Two things happen, the lower interest rate lowers the monthly payment, but you've also reset the clock to go out another 30 years (vs the 26 years remaining of the previous loan). Of course you could refinance into a shorter term loan.
I refinanced from my original 30 year loan @5.5% into a 15 year loan @ 2.99% and had a lower payment.  I might be wrong but I have a feeling people will look back on the interest rates of a few years ago as multi-generational lows.

 

[JohnRoberts]

I'm still learning about finances. I wish they would make it a requirement for high school.

One thing that confuses me is the refinance thing. I get how getting a lower interest rate works in the long term as a whole in regards to a mortgage. The thing that I'm unclear about is that it seems that , in the beginning of a home loan, most of the money paid into it goes to the banks and towards the interest and it takes many years for that balance to reverse where more money goes to the principal instead. So the banks get their cut first so to speak off of the amount of the loan.? So a $300000 house will cost double that with the banks making most of their money before you pay off your home?

Example I found online

$200000
30 year at 6%
Payments $1200/month

$950 goes to interest
$250 goes to principal (around 17years for this to reverse course)

so 4 years in, $57,600 paid

$45,600 went to bank ( interest)

$12,000 went to principal



When you refinance at this point (4 years) , your loan will maybe have a lower rate,  but does this time clock reset and basically the new loan payments start going towards the interest first again and it again takes years to find that principal balance being paid more? . I hope I'm being clear.

This is personal finance 101...

There isn't a clock per se, but interest is calculated based on the amount of debt still outstanding every month.

For simplicity lets assume a fixed interest rate, constant monthly payment, installment mortgage loan.

From that monthly payment, first the interest due on the outstanding loan balance is deducted. Then the amount left over after the interest is paid, is used to reduce the loan balance (aka principal). 

In each subsequent month the debt balance (principal) gets smaller incurring less interest cost, and more of the payment is used to reduce the debt (principal).

The shorter the loan term, and higher the monthly payment, the faster the debt gets reduced. In a several decades long mortgage the early years monthly payments are indeed mostly consumed by interest.

An important thing to understand about "refinancing" is the extra fees and closing costs that banks charge. This is how the banks make their money, and why they are so happy to rewrite loans at lower interest rates (easy money in hand now, for less earned later over decades). Besides that many banks resell mortgage paper, so the fees from refi is their dominant revenue. 
=====

I have written about this before but many with large student loans do not understand the basic loan mechanics.

When student borrowers are granted relief from making monthly payments, the loan principal is still incurring an interest charge. That monthly interest due gets added to the principal, so over time the debt grows larger... not doing them much of a favor. (This is called negative amortization)

When getting a mortgage shorter is better (if you can afford the payments). Also confirm that there is no pre-payment penalty. I paid off my home mortgage years before it was due, because I had the cash and it was a good return for that cash. I don't recall the exact mortgage interest rate (I assumed an existing mortgage so didn't negotiate it). It was in the low teens and maybe adjustable. 

Historically fixed rate 30 year mortgages were as high as high teens in 1980s, but they also played games with ARMs (adjustable rate mortgages) to deal with changing interest rates.  ARMs started out lower than fixed rate loans, but could be adjusted higher later.

JR

 

[dmp]

I have written about this before but many with large student loans do not understand the basic loan mechanics.

Not surprising that young people that aren't fully educated wouldn't be ready to make major decisions yet...
I was lucky to have parents that wouldn't hear of it and I was able to go to school when it was still affordable.

 

[JohnRoberts]

To take a break from the politics...

But President Trump is now tweeting about it, perhaps to give himself a scape goat if/when the market corrects. (past due, probably a buying opportunity for kids with longer investment time horizon)

something interesting is happening with interest rates.

Bond markets are supposed to be smart money and generally are. The fed can wiggle the short term interest rates but long term interest rates are a sentiment measure set by the bond markets.

A 30 year decline looks like it might be over.  The 10 yr treasury rate has broken above the declining channel.

the fed is both raising short term rates, and reducing their portfolio...(so working two levers).  The international economy is softening and some signs of stress are showing in domestic market.

What happens when interest rates decline? For housing, people can refinance and lower the monthly payment. And for the same monthly payment, people can buy more expensive houses. So declining interest rates provide a continual boost to spending.

The housing industry support is eroding... homebuilder stocks are down for the year.

Rising interest rates will be challenging for areas like housing.

Automotive sales are hurting too... but auto has multiple factors working against them.

But better rates give savers a safer way to get a return on investment.

wouldn't that be nice... best I could get on a CD was 2.75% a few months ago (for 2 year paper).

Now if the economy crashes and we have a recession, interest rates will try to drop again.

the inverted yield curve generally presages a recession, but historic low unemployment is not consistent with that scenario (different this time?)

But they are bouncing off the floor now (0%).

yup, you need to raise rates, so you can drop them later, but don't need to raise too much/too fast...  Inflation seems tame, but I don't trust all the inflation measures. Lots of input costs are rising this will have to show up eventually. 

And negative interest rates seem like a greater fool theory.

Didn't stop EU from going there.  :

JR

 

[dmp]

The fed can wiggle the short term interest rates but long term interest rates are a sentiment measure set by the bond markets.

Is it sentiment? This is something I have trouble wrapping my head around. It's supply and demand. If less buyers show up to bond markets, rates go up to try to bring in more buyers. The whole sentiment idea is confusing to me.

the fed is both raising short term rates, and reducing their portfolio...(so working two levers). 

Don't forget the Federal deficit. Supply of Treasuries is increased with more debt.  This + QT is uncharted territory.

the inverted yield curve generally presages a recession, but historic low unemployment is not consistent with that scenario (different this time?)

huh? Unemployment rate typically bottoms out before recessions.

https://fred.stlouisfed.org/series/UNRATE/

Yield curve actually steepened recently as 10yr rates rose. Not inverted yet.  The fed controls the short end with the overnight lending rate but has more trouble with the long end (ie 10yr). They are hoping for a soft landing by raising rates.

Didn't stop EU from going there.  :

Yes, and Japan I think. People have trouble accepting a change like this. There's been a 30 yr bull market in bonds. Why? Because every time interest rates fell, older bonds rose in value. So bond investors have been in a bull market for this whole time - their bond portfolios appreciated as interest rates fell. They don't want to let go of this paradigm so they might fool themselves into thinking this will last even as interest rates fall below zero (I've read this, I don't know any bond investors personally). So it's still a bull market (i.e. older bonds increase in value as the interest rates drop), even as rates drop below zero.  By why would a rational person buy an asset that they LOSE money on? That does worse than just holding cash? That's why I think of it as a greater fool scenario. 

 

[JohnRoberts]

Is it sentiment? This is something I have trouble wrapping my head around. It's supply and demand. If less buyers show up to bond markets, rates go up to try to bring in more buyers. The whole sentiment idea is confusing to me.

sentiment about the future... Fear and uncertainty drives money to safety (like long term government debt). Not to mention that high bond rates, pulls investors out of bond equivalents (high dividend paying blue chips, like utilities). IMO there is more going on in the market as love for the big tech/communication stocks is fading. This could feed on itself if momentum traders jump ship as people and funds try to lock in gains for the end of the year.

Don't forget the Federal deficit. Supply of Treasuries is increased with more debt.  This + QT is uncharted territory.

indeed... we are still unwinding the "Big experiment" Ben Bernanke put us into. Hopefully the faster GDP growth rate (4%?) will help, but Republicans have not exactly been paragons of fiscal restraint (they spend too much too).

huh? Unemployment rate typically bottoms out before recessions.

Are you predicting a recession soon? I'm sure we will get one eventually, always do.

I'm not sure unemployment has bottomed yet.... some employers are actually waiving drug tests to get more eligible workers. That might explain some customer service issues, but the AI they increasingly use to replace workers isn't very smart either. 

https://fred.stlouisfed.org/series/UNRATE/

Yield curve actually steepened recently as 10yr rates rose. Not inverted yet.  The fed controls the short end with the overnight lending rate but has more trouble with the long end (ie 10yr). They are hoping for a soft landing by raising rates.
Yes, and Japan I think. People have trouble accepting a change like this. There's been a 30 yr bull market in bonds. Why? Because every time interest rates fell, older bonds rose in value. So bond investors have been in a bull market for this whole time - their bond portfolios appreciated as interest rates fell. They don't want to let go of this paradigm so they might fool themselves into thinking this will last even as interest rates fall below zero (I've read this, I don't know any bond investors personally). So it's still a bull market (i.e. older bonds increase in value as the interest rates drop), even as rates drop below zero.  By why would a rational person buy an asset that they LOSE money on? That does worse than just holding cash? That's why I think of it as a greater fool scenario.

Sorry to make this about me,me,me... but. At my age I should hold a majority of bonds in my portfolio.... but I still can't wrap my head around buying bonds in an increasing interest rate environment (as rates go up bonds go down). Buying debt now is almost as bad as buying a new car, sure to drop in value (but cars don't pay interest) : .

JR

PS: There are other wild cards like China recently selling a few $B of dollar denominated debt (i wouldn't buy those either). China may be opportunistically building a position to use as leverage, who knows? China plays a long game but also has some short term issues with their domestic economy.

 

[dmp]

Are you predicting a recession soon? I'm sure we will get one eventually, always do.

I'm not sure unemployment has bottomed yet....

I think there are many signs pointing to a recession in the near future... but I don't want to make predictions because I'm terrible at it.
I thought there was going to be a recession in 2016 when manufacturing and oil slumped... now that is being called a 'mini' recession (not many people really noticed).
I definitely was surprised by the 2017-2018 appreciation in equities.
It's really hard to time markets - almost as hard as beating the house at a casino /s

The big question in unemployment is how many people are on the sidelines, not in the official stats. Looking at the overall participation rate gives another important piece of info.

The classic headwinds for the economy late in the debt cycle is increasing wages (pressuring profit margins), increasing interest rates (higher debt service payments), and a pullback in consumer spending (after skyhigh enthusiasm, which is where we are now). Housing and Autos are already in decline.
Zombie companies start to crash (sears is filing for bankruptcy currently)

 

[Phrazemaster]

Yeah, that's just how the math works out. 

Actually - that’s just how theyworked out the math. Totally and completely to their (the bankers’) advantage.

It wasn’t just a quirk of math...but you knew that...

 

[Phrazemaster]

Historically fixed rate 30 year mortgages were as high as high teens in 1980s,

Yes but housing was much, MUCH cheaper...

 

[dmp]

Actually - that’s just how theyworked out the math. Totally and completely to their (the bankers’) advantage.

It wasn’t just a quirk of math...but you knew that...

Maybe I'm not following what you're saying... but what I meant was you can work out the same thing in a simple Excel spreadsheet. There's no complicated shenanigans to it.
You are borrowing money (say $200,000) and paying a fixed interest rate. For the first year you calculate the interest, and increase it by some amount to pay off some principal. Next year same thing. There isn't any conspiracy to how the P&I is calculated for a fixed interest, fixed term loan. 
Now adjustable rate mortgages are a different ballgame and that's where banks really get people into a loan that they shouldn't be doing.  Or student loan terms that are awful, high interest rates and ineligibility for bankruptcy etc...
And you should always make sure there is not early payment penalties.

It is to the banks advantage when interest rates fall because they are getting interest on old loans at a higher rate than the bank can currently borrow more $ at. But as rates rise and people have loans locked in at lower rates, then the banks aren't at an advantage.

Right now I have a 2.99% loan that the bank would love to get rid of I assume, since they are now lending money at 4.5%

Yes but housing was much, MUCH cheaper...

And what will happen if interest rates do reverse the trend of the last 30 years.... I'm guessing housing will get much much cheaper. It will be a painful situation. best we can hope for is interest rates remain low for the next few decades.

I saw this pretty cool plot of interest rates over the last 3000 years. Not sure what the pre 1800 data is based on...
But the late '70s peak was definitely a noticeable outlier

 

[JohnRoberts]

I think there are many signs pointing to a recession in the near future... but I don't want to make predictions because I'm terrible at it.
I thought there was going to be a recession in 2016 when manufacturing and oil slumped... now that is being called a 'mini' recession (not many people really noticed).
I definitely was surprised by the 2017-2018 appreciation in equities.

So was George Soros who shorted the market and lost something like $1B before covering his short.

It's really hard to time markets - almost as hard as beating the house at a casino /s

can't beat the house either statistically

The big question in unemployment is how many people are on the sidelines, not in the official stats. Looking at the overall participation rate gives another important piece of info.

yup, workers still coming out of the woodwork, but we also have boomers (those losers) retiring....  8)

The classic headwinds for the economy late in the debt cycle is increasing wages (pressuring profit margins), increasing interest rates (higher debt service payments), and a pullback in consumer spending (after skyhigh enthusiasm, which is where we are now). Housing and Autos are already in decline.

indeed interest sensitive housing and car loans are already soft... bad time to be selling new harleys, but maybe good time to buy used.

The consumer is still alive and well, still increasing household debt.. This will end eventually, has to, but strong employment helps consumer enthusiam.

I can't predict the future either, but consensus is for maybe next year...

Zombie companies start to crash (sears is filing for bankruptcy currently)

Sears has been a basket case for a long time. They bought KMART at the wrong time to dive into brick and mortar, and is downhill since then. Eddie Lambert is still a billionaire doing some self dealing with sears holding through his closely held ESL hedge fund. 

Sears will likely declare bankruptcy to scrub off more real estate leases in unprofitable malls shrinking in size again. Eddie has already sold off craftsman (iconic tool brand), and is selling Kenmore appliances on Amazon. That brand may be sold too.

Sears has gone full circle they were the original mail order disruptor, to now being disrupted by web sales. I could imagine them ending up a profitable website, but much smaller.

Indeed the tide going out as credit tightens will reveal who isn't wearing their trunks. The too easy credit has distorted the economy longer than some have been paying attention. It is always amusing to listen to young analysts.  :

JR

PS: I can't help myself I just bought another common stock... it was on sale at a deep discount from when I first looked at it a few weeks ago (down over 30%). Not good judgement to try to catch a falling knife so we'll see, how deep this dip goes, and if I bought a value trap.

[edit-  for any worried I managed to catch the falling knife with minimal injury.... stock fell another 1% or so after I bought it before bouncing. I am now up over 5% including the transaction cost, so it appears it was indeed oversold. Better to be lucky than good. [/edit] 

@Phrazemaster. Yes, houses were cheaper back in the 80s, but I still had trouble getting a mortgage back then as a small business owner.  My current house that I bought in '85 was much easier, because in MS it was silly cheap, and I was able to cover the original owner's equity out of my pocket cash (actually bank account balance). I assumed his existing mortgage, and then paid that off within a few years, as better use for my spare cash.

You are correct that interest rates do directly affect the ability of people to afford houses, modulating home prices up/down. Future expectations of prices also is a factor. As during the housing bubble people gambled that house prices would keep going up to the sky (they didn't). 

While its all relative, interest rates now seem too cheap IMO.

 

[Phrazemaster]

Maybe I'm not following what you're saying... but what I meant was you can work out the same thing in a simple Excel spreadsheet. There's no complicated shenanigans to it.
You are borrowing money (say $200,000) and paying a fixed interest rate. For the first year you calculate the interest, and increase it by some amount to pay off some principal. Next year same thing. There isn't any conspiracy to how the P&I is calculated for a fixed interest, fixed term loan. 
Now adjustable rate mortgages are a different ballgame and that's where banks really get people into a loan that they shouldn't be doing.  Or student loan terms that are awful, high interest rates and ineligibility for bankruptcy etc...
And you should always make sure there is not early payment penalties.

It is to the banks advantage when interest rates fall because they are getting interest on old loans at a higher rate than the bank can currently borrow more $ at. But as rates rise and people have loans locked in at lower rates, then the banks aren't at an advantage.

Right now I have a 2.99% loan that the bank would love to get rid of I assume, since they are now lending money at 4.5%


And what will happen if interest rates do reverse the trend of the last 30 years.... I'm guessing housing will get much much cheaper. It will be a painful situation. best we can hope for is interest rates remain low for the next few decades.

I saw this pretty cool plot of interest rates over the last 3000 years. Not sure what the pre 1800 data is based on...
But the late '70s peak was definitely a noticeable outlier

Hey dmp, no disrespect meant. I appreciate your thoughtful posts and enjoy reading them.

You are correct that’s “just how the math works out” but step back - who decided to use that math in that way?

As Scott said the interest is stacked in favor of the banksters. If you look at how much interest is paid over 30 years it’s often over 85% of the original loan, sometimes even more than 100% interest. I get “that’s how compound interest works” but let’s be honest, who invented it and why?

Math is a construct, a human invention or discovery. How we use it is up to us.

So yeah, the deck is stacked against the borrower and of course it’s on purpose. But knowledge is power, and if you pay off faster as mentioned you pay far far less.

JR thanks for sharing.

 

[john12ax7]

There is nothing mischievous about amortized loans,  and certainly not math in general. People like fixed payments,  so you pay a greater ratio  of interest in the beginning.  You could also do it with fixed principal payments,  you would pay less in total,  but the initial payments would be higher and then decrease over time.

Homeowners tend to benefit overall with the arrangement,  the victims are more those who can't afford to get in the game.  And the actual mischievous part is how the banks aquire (create)  the money to lend.

 

[Phrazemaster]

There is nothing mischievous about amortized loans,  and certainly not math in general. People like fixed payments,  so you pay a greater ratio  of interest in the beginning.  You could also do it with fixed principal payments,  you would pay less in total,  but the initial payments would be higher and then decrease over time.

Homeowners tend to benefit overall with the arrangement,  the victims are more those who can't afford to get in the game.  And the actual mischievous part is how the banks aquire (create)  the money to lend.

Respectfully I disagree. The math is designed so the bankers get a ton of money up front. It's not right, it's not fair, and I'm sure a different math could be created to make it even.

Are you really telling me no one could come up with another scheme mathematically that would make the interest and principal payments equal?

 

[dmp]

Hey dmp, no disrespect meant. I appreciate your thoughtful posts and enjoy reading them.

You are correct that’s “just how the math works out” but step back - who decided to use that math in that way?

As Scott said the interest is stacked in favor of the banksters. If you look at how much interest is paid over 30 years it’s often over 85% of the original loan, sometimes even more than 100% interest. I get “that’s how compound interest works” but let’s be honest, who invented it and why?

Math is a construct, a human invention or discovery. How we use it is up to us.

So yeah, the deck is stacked against the borrower and of course it’s on purpose. But knowledge is power, and if you pay off faster as mentioned you pay far far less.

JR thanks for sharing.

Phrazemaster,
No problem, I see where you are coming from now. I think you are talking about debt in general - not the specifics of a 30 yr fixed rate mortgage.  I've been very interested in this lately. 
The greek word for sin in the Bible can alternately be translated as debt. There is a passage in the bible that specifically uses it in this way.
A really interesting book that goes into the history of debt (including that detail about the bible) is Payback: debt and the shadow side of wealth by Margaret Atwood. I read it last year and learned a lot from it. 

 

[Phrazemaster]

Phrazemaster,
No problem, I see where you are coming from now. I think you are talking about debt in general - not the specifics of a 30 yr fixed rate mortgage.  I've been very interested in this lately. 
The greek word for sin in the Bible can alternately be translated as debt. There is a passage in the bible that specifically uses it in this way.
A really interesting book that goes into the history of debt (including that detail about the bible) is Payback: debt and the shadow side of wealth by Margaret Atwood. I read it last year and learned a lot from it.

Love it! Man you write some quality posts!

Thanks for sharing.

I teach Excel a lot. We spend time developing a Loan Calculator for paying off a house. So this topic is near and dear to my heart. But yes the specifics of how the first years, the bank gets so much interest and the principal gets no love, is not right. According to the only person who matters, me. 

Now if I was a bankster I might think differently...

Thanks,

Mike

 

[Phrazemaster]

I had a buddy that tried to explain this to me some time ago..... It was pretty interesting....Also the creation of debt..... I kinda brushed it off as he was kinda radical and I was young but over the years I've kinda put some pieces together that seem to fit his thinking... Definitely wild stuff....

Well...ahem...the banks actually don't acquire the money they lend. They "make it up" - they only have to have 10% in reserve to make a loan. The rest is a digital counterfeit - but no actual bills are ever printed. But the borrower has to pay back with "real" money that the bank never actually had. That's why they say "banks create money" when they make loans. Somehow, it's "legal." Look up Fractional Reserve Lending.

Then normally you have to make a down payment. If you pay them 20% down, they just made a 100% return on their investment the day escrow closes. The rest of the 30 years' worth of interest you pay them is pure gravy on top of having doubled their money. No wonder they are always in such a hurry to close a loan.

It's the biggest con job ever and it's right in front of us the whole time.

 

[dmp]

There is something really neat about compound interest... which is that in the limit of compounding the irrational number e comes out, (e=2.718.... ,Euler number).

This was how the number e was first discovered. Later on the implications of natural logarithms and calculus. 

Basically the more frequently interest is calculated, or compounded, (yearly, monthly, daily, every second, etc) the faster the principal grows (or declines in the case of debt). The formula (1+r/n)^n, where n is the compounding goes to e, 2.718..., when n goes to inf.
I think I got that right but a google search should fix any goofs I made.

 

[dmp]

I had a buddy that tried to explain this to me some time ago..... It was pretty interesting....Also the creation of debt..... I kinda brushed it off as he was kinda radical and I was young but over the years I've kinda put some pieces together that seem to fit his thinking... Definitely wild stuff....

Yeah, and that gets into fractional reserve banking and why the Fed sets an overnight interest rate in the first place.
I swear there is more misunderstanding of what this is than just about anything on the internet!
People love to demonize the Fed.

The way it works is the Government says banks can only lend 10% of what they have on deposit.
Say one person (frank) deposits $1000. The bank has to keep $100 on reserve (10% on deposit with the Fed) . They lend out the other $900 to another person (wendy). 
Now say wendy buys a boat from mark for $900 and mark deposits the money at the bank. The bank puts $90 on reserve and again lends out the remaining $810.  So now the bank has $1900 in deposits, $1710 in loans, and $190 in reserve.
This continues through a bunch of people... 
You'll find that the original $1000 grows to $10000 in deposits, $1000 in reserves, and $9000 in debts. Money is conserved, but the bank only has $1000 in reality (on deposit at the Fed) while the rest of the money is out in loans.  I repeat, no money is created out of thin air!
So the reserve rate sets the multiplier of the money supply (in this case 1/0.1 = 10). In good times this works fine and is very stimulative for the economy.  But in bad times (i.e. recession), a high money multiplier leads to instability.  If Frank, Mark, etc all go to the bank at the same time to get there deposits, the bank does not have the money for them.  This is a 'run on the bank' scenario.
Another detail is the US Government insures deposits when the banks obey the reserve requirement, i.e. the gov acts as the lender of last resort, when depositors all come for their money.