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Low rates allow low repayments. So do longer terms. But neither seem rational. Irrational expectations of long term capital gains keep the structure together

Low rates allow low repayments. So do longer terms. But neither seem rational. Irrational expectations of long term capital gains keep the structure together

By David Chaston

High house prices cause mortgage payment stress.

Low interest rates give buyers a better ability to afford those prices.

However low interest rates allow buyers to bid up prices to their loan repayment affordability level.

That is why many analysts point out that it is low interest rates that 'cause' high prices when there is limited supply. That is, low interest rates expand the pool of buyers who can 'afford' higher priced houses.

This is the basis of the claim that there is an 'asset price bubble' in the housing markets, especially in Auckland, Canterbury, and the Central Otago Lakes region.

But from an individual buyer's perspective, keeping weekly or monthly mortgage payment levels within a household's budget are an essential criteria for deciding whether to try and buy, or not.

Interest rates may currently be low (in fact, there is an outside chance they could even go lower), but they are not the only technique you can use to keep weekly or monthly payments low.

You can also push out the term of the loan.

Twenty five years ago, a standard home loan term was 15 years.

But since then we have seen it creep up to 20 years, then more recently 25 years.

Now many banks will accept 30 year terms for their mortgage documentation.

The longer the term, the lower the regular repayment amount.

But there are two serious catches.

Firstly, if you want to have your home loan fully repaid by the time you retire at say age 65, you would need to start repaying that loan by age 35.

Secondly, 'going long' on the repayment will mean you will be paying the bank seriously more in interest.

It is eye-watering.

Before you choose to take out a longer mortgage, take a look at this table.

It only shows the interest component of what you will pay back. You will need to add the loan principal to get the total repayments you will need to make.

Home loan interest costs
based on a $300,000 loan, plus  
An interest rate of ... 5.60%* 6.00% 6.50% 7.00%
over ... $ $ $ $
15 years will cost ... 144,096 155,683 170,398 185,367
20 years will cost ... 199,354 215,830 236,813 258,215
25 years will cost ... 258,066 279,871 307,686 336,101
30 years will cost ... 320,005 347,515 382,633 418,527
* the current average bank two year fixed rate is 5.58%

This table also shows what will happen if interest rates rise. The downside to household budgets will be serious if rates over a 25, 30 or 35 year period rise even one or one and a half percent.

Over a long period you have contractually accepted the obligation to pay back the principal. But you have also opened yourself up to accepting market rates over that period. Who knows what and when rates will do over such a long period.

A thirty year loan at the current two year fixed rate of 5.6% (the bank average) will see you pay more in interest ($320,005) over that period than you borrowed in the first place ($300,000).

A relatively small rise in interest rates to just 6.5% would see a 25 year mortgage require more in interest than the original borrowed amount.

No wonder there is a reliance on capital gains. Such prospects are a mental salve to justify taking on such a large interest-paying obligation. But that is irrational over such a long period.

However, long term rationality does not feature much when housing markets get exuberant.

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49 Comments

It's not about "rational" or "irrational."

It's about MAGIC!

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... luckily for us , we're in an extended period of irrational exuberance , not in a bubble ... therefore nothing bad can happen from here .... so keep borrowing and buying , folks ...

On the other hand , some gloomsterisers believe that houses are no different from any other investment class , and prices go in cycles ... it's just that those cycles are so long that everyone from pony-tail tugging PM's right down to the humble Gumble bear forgets about them ... and assumes that the good times will continue forever ...

... or it could just be MAGIC ! .... yessssssss , I'm going with magic .... the result of the banks and the real estate agents ... those old tricksters , up to their mischief once again ...

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Some friends own a cafe.

They built it from scratch and many claimed they were mad -- including, to my eternal shame, me.

The cafe was a 'best of everything' deal and it is one of the most successful small businesses you'll encounter.

My friends live by quality -- great food and coffee, great service, great everything -- and as a result get more repeat business (and new business) than anyone else I know.

The cafe employs more than a dozen people, makes a lot of money and is an asset to the town.

Why did the fools waste all that cash and effort when they could have invested in houses?

You can't lose with houses.

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Yes - what idiots!
If only they had snapped up a few dozen Auckland houses with the business startup cash as a 20% deposit (or even lower as banks were lending 90% to 95% when they had started their business), they'd be many folds richer - such idiots!!!!!!!!
Now with a business, you ahve to pay GST and god forbid, income tax too! No tax free capital gains? Such idiots!

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Investing is always easy with hindsight, more difficult to do consistently and prospectively though. Assuming that an asset class which has performed so well recently will continue to do so seems risky, to say the least.

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But what about the effect of inflation over the term of the loan? Interest rates should only increase because of increasing inflation, correct? So the total amount you pay in todays dollar terms is not all that scary is it. Not buying a house and renting for 30 years is far more irrational.

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" Interest rates should only increase because of increasing inflation, correct? " Not quite right. Interest rates could be 0% and if there was a liquidity squeeze ( it happens!) and the banks had no capacity to lend any more out, then the price of money - the % rate - is irrelevant. Usually though, when that happens, rates increase very quickly as banks capitalise on what remaining liquidity they do have to make more margin. QE, isn't a long term solution. It merely brought forward tomorrow's liquidity into today. What happens when we get to tomorrow?

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It has now become fashionable in the world of high finance to express extreme consternation about reduced liquidity in the bond market. Last week, Jamie Dimon spelled out the problem as follows:

The likely explanation for the lower depth in almost all bond markets is that inventories of market-makers’ positions are dramatically lower than in the past. For instance, the total inventory of Treasuries readily available to market-makers today is $1.7 trillion, down from $2.7 trillion at its peak in 2007. Meanwhile, the Treasury market is $12.5 trillion; it was $4.4 trillion in 2007. The trend in dealer positions of corporate bonds is similar. Dealer positions in corporate securities are down by about 75% from their 2007 peak, while the amount of corporate bonds outstanding has grown by 50% since then. Read more

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That is the accepted wisdom. It wouldn't have worked in Japan.

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Around the year 2000 thru 2002, when everyone was fretting about the Y2K bug, and in the grip of the dot-com-boom-mania I was constantly hearing scuttlebutt around the traps that there was a tsunami of hot money flooding around the globe every night. I don't hear too much about it now. Well it's still there, sloshing around looking for a home

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looking for a home - lol - we can take that literally.
.
and yes, it's still there and has even increased. It's well known that all the QE that's been done over the past decade or so, has inflated stocks and created bubbles like the housing one in Auckland.
.
The question is - will this surplus cash ("newly created wealth". anyone?) be mopped back up again? if so, how? and when?
And what will it cause in the markets?

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Well there is talk of a few US$trillion (yes, billions are just so last decade) created over the last few years that might fly home if and when US interest rates finally rise. Could be a serious worry. The stuff is borrowed into existence at almost zero interest rates and then sent outside the US looking for yield. The trade unwinds when the USD goes up or when US interest rates go up. It can unwind very fast, eg 1998. These things start slowly at first and then speed up.

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the chances of a interest rise in the USA have impoved overnight to 40% in sep and 80% in dec
BUT we will have to wait and see , the FED is so jittery that one bit of bad news could set off the printers again

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Plenty of old elephants trumpeting their view in small rooms.

The Federal Reserve risks another bond market tantrum if it continues to hold off on a rate hike, a former U.S. central banker said Tuesday.

Lawrence Lindsey, who served at the Fed in the 1990s before joining the George W. Bush White House, said the central bank had delayed normalization of rates “way beyond what is prudent.”

“You would have been laughed out of the classroom” in graduate school if you proposed holding rates at zero with the unemployment rate at 5.4%, as the Fed is doing now, Lindsey said during a panel discussion on Fed policy at an event sponsored by the Peterson Foundation. Read more

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.. one theory canvassed on CNBC (UK) was that central bankers will keep interest rates so low that they eventually blow up the entire world's financial system ... can't imagine that was an original thought ... bubble bubble toil and ... POP !!!

Got some gold .... Justin Case !

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Some are beginning to think it's close at hand.

What is causing VaR shocks and why are they happening often? We argued before that one of the unintended consequences of QE is a higher frequency of volatility episodes or VaR shocks: investors who target a stable Value-at-Risk, which is the size of their positions times volatility, tend to take larger positions as volatility collapses. The same investors are forced to cut their positions when hit by a shock, triggering self- reinforcing volatility-induced selling. This, we note, is how QE increases the likelihood of VaR shocks. Read more

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The danger with lower and lower interest rates (margins), is that any failure can't be covered, which risks the whole setup getting the speed wobbles and blowing the golden rivet at such pressures....

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As subtle as it may seem, the point I was making was the tsunami of cash was sloshing around 5 years before QE even started. QE commenced after the tsunami receded. QE was implemented to maintain the status-quo, instead it magnified the problem. There were 5 stimulus packages. QE's I,II,III started because the first two programs didn't even touch the sides

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It really turned to a flood after the NY Fed bailed out John Meriwether's Long Term Capital Management in 1998.

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"After the “decade of greed” eighties excess, the post-Bubble backdrop was one of a highly impaired banking system. The savings & loan industry had collapsed. The Texas banks were wiped out. Even some major banking institutions (Citibank!) were in trouble, especially after the collapse of the coastal real estate Bubbles (East and West, commercial and residential). Greenspan took extraordinary measures, adopting “activist” policymaking that the Fed believed was justified because of mounting risks of economic depression and deflation. They’ve been fighting this bogeyman on and off now for 25 years.
http://creditbubblebulletin.blogspot.co.nz/2015/05/my-weekly-commentary…

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the Undertow is a well known result of water Tsunami. No surprising it also occurs in money ones too.

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Gummy Bear is right the central banks are trapped any attempt to raise rates beyond a token gesture of .25% - .50% the pack of cards will come crashing down. Just too much debt leveraged against a World of inflated speculative assets. Just have to hope for the best i.e It lasts long enough for you to make your lot.

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Don't the property investors/landlords rely on the tenants paying both the interest and principal ? Is that not the lure seen in the famous Singapore pitch aired recently ?

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Does MacDonalds rely on the customers covering the staff and the equipment&building as well as the burger ingredients?

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No, as the IRD ie you and I will pick up tab in the form of the landlord gets a tax rebate if he's "losing money" on the "business"

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all businesses get that treatment steven, and so do wage earners

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businesses carry the loss forward to offset against future profits.

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yes same as houses. Or you can be set up as a "Look Through Company" formerly known as a Loss-Attributing Company, to allocate the loss in the companies records, in the same proportions as the shareholdings, to pass that loss back to the shareholders, like you would a dividend, and offset the shareholders personal income. Useful if the company isn't likely to have a profit to offset in the following year and/or the shareholders have personal income near to tax rate thresholds.

In the case of proprietorship or partnership the "Loss from Trading" space on a standard IR3 can be used to offset business trading losses against wage and salary earner income. You do have to be able to document the trading business, and be consistant (ie keep real books and asset schedules).

again renting houses, whether as a sole trader or company is really no different to any other service business.

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For property investors, lower interest rates is the only way to lower repayments because they are already on an interest only loan (paid by suckers sometimes known as tenants).
Basic concept in property investment has always been - buy 2 properties, 10 years later, sell one and pay off the other through capital gains whilst being as negatively geared as possible (i.e. interest only, use extra equity for further purchases etc) for tax advantages!!!!

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I thought only commercial properties do interest only mortgages? or is it "normal" for housing "investment" as well?

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normal for housing, especially when splitting between an interest-only fixed-term low rate, and a higher rate floating interest&principle.

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have you tested that basic concept. from what I understand and experience in proeprty trading that wouldn't work and would be a quick trip to bankruptcy. (in practice)

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It has worked and does work.
I know people who bought 5 Auckland houses in early 2013 (2 years ago). If they wanted, they could sell 2 and get 3 mortgage free today. Of course, they kept getting tax refunds for the 2 years too.
Yes, you do have to watch your cashflow to not go bankrupt but with prudent financial management, works like a charm!!!
Property trading is a different game (and in my opinion, not worth it) primarily because you have to pay GST and tax on your profits which erodes almost 50%.

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This is as bad as me saying my shares are worth so much today. Until I sell them they are not worth anything and the same goes for the five houses owned by the people you know. I would have thought it would be a good idea to sell all of them now as there is a definite momentum amongst the RB and the government to get hold of the Auckland bubble. The two interventions so far will be followed up by other measures if necessary. No politician wants to be remembered as a failure and on this matter National are failing.

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Property is not like individual shares. With shares, you have to exit at the right time.
With property, it will always increase every year!
Hence the terminology "property-ladder" not "sharemarket-ladder" ;)

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Really, try telling that whopper to ppl have have seen losses wiping out their deposit in lots of places throughout the world.

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... you obviously have not been frequenting enough property seminars , my friend .... even old " Ponytails " himself is a convert .... property only goes up , has been for 45 years , must be forever ....

This is NZ , we're different , special ... God's chosen property investors ...

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I can challenge you anytime that there are far more people who have lost out on the sharemarket than property.
Property is a real asset as supposed to paper assets and will always go up in value over the long term.
What wins? 1987 bought shares or 1987 bought property?

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Bollocks. Its no more a paper asset that you property title. Another property spruiker holding his breath huh?

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Gordon is correct.

Your people people are holding paper. If they decided to action that plan they will find it is much harder to get the exit and re-entry to go to plan. Also such a technique relies on Auckland style bull market - it would be like saying you could buy into Xero at $5, then sell at $10, then buy twice as many. Doesn't quite work like that in practice.

the property ladder works because the leverage effect or the security. Once you're holding one property you no longer have rental outgoings you have equity investments (and interest expenses). Using the property as security, a loan can be taken towards and leveraged property, and the investment used to pay down the interest and principle.

you can also use ratchet leverage on share portfolios but the units are so much smaller, fungible, and diverse. You can buy energy and biotech, or two different banks, all on the same market. The equivalent is owning a house in Auckland and one in Wellington, or one in each Island. There are inherent difficulties servicing the properties as most long distance landlords can attest.
However the share portfolio is much harder to get leverage on, and you have to rely on "value" shares (that pay a dividend) to automagically pay down your leverage; whereas it's the growth shares that have the much faster performance on the sharecapital market (they don't pay a dividend because all the earnings are retained for growing the company faster) but such shares have little ownership value and can't be used to pay off the leverage (ratchetting).

IIRC the ratchetting is where you buy a parcel of shares (eg 1000) on leverage. Usually the lending party takes the rights to the dividends as their consideration. When the shares reach a certain value, then a portion of the shares are sold off on the open market, and that pays off a portion of the leverage.
It's a nice trick. You can get a parcel of 500 shares, for nothing and at little risk.

there are variants where the dividend received is capped, and any excess is used to purchase more shares or paid off the account.
Or that a purchase option is enabled that lets the client buy more shares (preferably leveraged or with excess dividend) should the price drop below a certain level (eg 50% of buy in) so when price recovers to existing level, they can sell down half to get "free" shares...and if the trend continues they have a larger portfolio at payout.

I'm pretty sure I got it right. It's been a while (20 years) since we did that.

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With Auckland houses up $1000 a day, why would they sell when they have enough cashflow to withstand?
You're talking nonsense - with the amount of leverage available for property vs that of shares, the property returns would knock shares down the gutter.
Plus the fact that buying investment properties = guaranteed rental income.
Growth shares provide 0% return and hence leverage is impossible without being bitten.

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With $1000 a day.... why would they sell?

Because they don't make a cent until they do sell (and that means they will be taxed on their intention to make a profit on the sale).

They can't sell off a part of the house (well not easily - Tenants in common, and syndications aside) yet shifting off parts of shares is very easy (and much cheaper).
If an Auckland house costs you 750k, that will get you a lot of shares.

But if you go into the bank see how much you need - yes the property can be leveraged more than the shares.

But high gain is higher risk. They don't make a cent until they sell.
The longer they hold on to get a better cap-gain the more they're playing the brinksmanship game. the only solution to that is pull out early.... which means they -must- sell.... but then where to put the money? Buying _back_ into Auckland when they just cashed out because of the risk...?? They just lost tens of thousands on the commission and legal fees !

You really want to make a buck, be like the 10acre block wealth generators...get your real estate license, and take the cream off each transfer (and far less personal risk)

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we will see bluntboy. Do you really think that the RB and JK are going to let Auckland property continue to increase in value as it has been? They are jus tinkering around the edges at present and if it does not stop rising they will just implement more measures. For some reason JK has failed to act earlier but he will act more strongly if he has to, just to get rid of the emails and constant nagging from people he talks to that Auckland has got ridiculous. He might be able to buy houses for his kids but not everyone is in his position.

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In many other Asian countries around the world (China and India)- property is passed down (inter-generations) as it is the safest asset and selling it generally means you wouldn't be able to buy it back - ever!
JK is a capitalist - he will always allow foreigners to buy houses and wants property to go up in value.
All MPs have huge property portfolios and will never let prices go down!!!

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... good on you , mate ... you keep the flag waving , buy buy buy ... someone has to to keep the momentum going ... Reverse Bank gov'nor Graeme Wheeler is helping , by signaling a halt to OCR rises ...

All the Gnats own properties ... you can't lose ... but , ummmm , I'll just watch things from the sidelines .... keep a wary eye on it all ... bye bye bye ...

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Lets blame the banks David because their ineptness has led us into a mess. When got my first mortgage it had repayments, and interest was not an option. Or even discussed.
Over the years I must have fillled a wheelie bin with letters from the bank offering me an increased credit limit.
The old dragon bank manager has been turned into a salesman. Corporate psychopathy.
I am very happy for banks to be private business. But their capacity for harm to us at a macro level using this sort of daft operation means they need to be regulated to hell. Like we do with electricians.
What is so hard about regulating some categories of mortgage lending so that there has to be a repayment element, leading to full discharge repayment within a time limit

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Accurate points David. But the trade does go to the person willing to pay more, that's the risk they take.

Only extra supply at the cheap end of the scale can improve that.

So going low interest (or interest free, in the likes of box dropping bulk retailers) has always been a way of increasing market share and getting the customers wallet before the next retailer sells harder and leaves you shut out.
This does run the risk of trapping future sales (that 30 year period) into the current business year period, costing economic and custom in the future...but there is no future if you can't get sales to keep the lights on (and staff paid).

So yes the lower rates does allow more demand, and higher bids. But does it reduce the number of people in the market?
More danger comes when the market is opened to wealthy big fish from bigger ponds then the little folk who rely on local business go the same way as small farmers....

We should have held interest rates up (but it's too late now), and made sure that the cost of building was low (reducing the cost of supply, and decreasing the limit cap effect of new builds vs old).

But no, the experts said this is the way to go. So I've said goodbye to the small productive quality farm, and just put an offer on a couple of small houses. 280k for the pair of 2bd with good location.

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NZ used to be a backwater. With tourism/ immigration/ Aucklanders spreading out. It is no longer a backwater. look at Queenstown. It used to have olde worlde charm. Eicharts pub: a wonderful public bar to play pool in with a fantastic view. Now they are building the most expensive hotel in NZ.
NZ will cease to be popular only if a financial crisis hits here harder than elsewhere.
Thankfully the NZ govt hasn't maxed out its credit card (yet). But unfortunately the councils and the new home owners are trying their hardest to make up for that.

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We were a backwater but now we have good hobbits.

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