The Crucial Fact About Mortgage Lending Today

By Gary North

did you know thatOne of the most important aspects of the decline of mortgage rates is the fact that most of the money is not going into the purchase of housing.

When we read of falling rates, and then we read about the recovering housing, we naturally assume that the two facts are linked. They are not linked.

Today, over three-quarters of all the demand for mortgages is for people who are refinancing their homes. This is an extremely good opportunity for people who are refinancing their homes. This week, my daughter had a visit from a real estate appraiser. She is going to refinance her home, assuming that the appraisal indicates that she is eligible for refinancing, which I think is likely. She lives in Nashville, and that was one city in which there was not a decline in the price of housing, 2008 through 2010.

It is a bad deal for people who lend money to the buyers of the properties. They lent money at a higher rate of interest. Now, because of falling rates, these buyers are going to new lenders, borrowing the money to pay off the loan entirely, and establishing a debt at a much lower rate of interest. It is going to save them a great deal of money. On the other hand, the people who originally lent the mortgage money are now stuck. The money has come back to them, and the rate of interest at which they can lend that money today is probably about half of what they lent at five years ago.

This points out the fundamental problem with becoming a long-term creditor. If the borrower can borrow enough money to pay off the debt, because of falling interest rates, the lender loses the advantage of the original high interest rates. He goes from high interest rates to nothing in one shot. Then he has to go into the existing credit markets. He will find that he can receive only a fraction of what he received before. So, because interest rates are falling, he has not been able to capitalize on these falling rates. It seemed that he was getting a nice rate of return, compared with everybody else. Then, without warning, the borrower pays off the money, and the original borrower finds that the great opportunities no longer exist.

On the other hand, if we get into a mass inflation situation, and interest rates double, the lenders get hurt because of the depreciation of the money and also because his competitors are getting paid twice as much as he is. He allowed the lender to lock in a rate, and then monetary policy pushed up the rates. The usual explanation for the rise in rates is expectation of price inflation. So, the person lent money long-term in a market that was regarded as protected against price inflation, and then monetary policy produces price inflation.

This is why long-term lenders are in an asymmetric arrangement. If interest rates go up, they lose. If interest rates go down, they will probably lose. The lender will get smart, borrow enough to pay off the entire loan, and lock in a much lower rate of interest. This is what is happening today.

So, the mortgage money that is issued by new lenders is being used to undermine the high rate of returns that the original lenders have been making. This does not lead to more houses being constructed. It just means that the debtor is able to reduce his obligation at the expense of the creditor, because there are new creditors who are willing to lend them the money to pay off the old creditor.

The new creditor will find that he also has made a mistake. He has locked in a loan at something under 4%, and price inflation is likely to push rates to double, triple, or even quadruple this rate. It depends on how extensive the expansion of money is, and how much the bankers redeposit at the Federal Reserve in the form of excess reserves. In any case, it is highly unlikely that mortgage rates are going to get cut in half in the next three years. It is far more likely they are going to increase.

So, the borrower is a winner. As long as he did not purchase a property that fell in value to below what he borrowed, he is still in pretty good shape. He is in a position to be in much better shape. This is why it is wise to be a borrower of mortgage money rather than a lender of mortgage money.

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