Saturday, May 26, 2007

Mortgages

Some facts about the current mortgage market in Canada (from CAAMP):

1. Over 70% of Canadians choose fixed rate mortgages
2. Over 20% have variable rate mortgages
3. The remaining % have combination mortgages

For the mortgages currently held by Canadians, the average mortgage interest rate is 5.1%, a rise from the 4.9% recorded a year earlier. This average rate is quite similar to the rates that are currently available for new and renewed mortgages. However, of course, individual circumstances vary:

• If rates remain at current levels, 66% would face increased interest rates at their next renewal, 32% would have decreases, and 1% would have no change in their interest rate.
• For those scheduled to renew in the next 12 months 50% would have increased interest rates, 48% would have decreases, and 2% would have no change.
• If rates were to increase by one-half of a percentage point from current levels, 74% of borrowers would face a rate increase at their next renewal; among those renewing in the coming 12 months, 58% would see increases.

BC mortgage holders are the most likely to have a variable rate mortgage at 32% as compared to 21% for all of Canada.

The average variable rate mortgage has gone from 4.4% last year to over 5.3% this year.

Here is an updated renewal gap chart.

43 comments:

mohican said...

I learned this week that the holder of a variable rate mortgage does not have his payment increased automatically if rates rise to keep him on his amortization schedule.

This means that when it comes time for renewal, he faces increased rates plus he must 'catch up' on his payments or increase the amortization of his mortgage.

Patiently Waiting said...

Yeah, that was a selling feature back when I was selling variable mortgages. Even if rates go up, your payment doesn't. You just pay-off less principle in your regular payments. Sounds wonderful, doesn't it?

casual observer said...

This may be a little off topic, but since the post is titled "Mortgages", here goes.

Mortgages, while allowing people to purchase homes and live in them while paying for them, have a downside as well. They have caused RE prices to be inflated. This has made it near impossible for the average person/family to buy a home without taking on debt.

It may seem strange to us today, but mortgages used to be rare, and short term (3-5 yrs.)History of Mortgages

QOUTE: "You may think mortgages have been around for hundreds of years -- after all, how could anyone ever afford to pay for a house outright? It was only in the 1930s, however, that mortgages actually got their start. And, it wasn't banks that forged ahead with this new idea; it was insurance companies. These daring insurance companies did it, not in the interest of making money through fees and interest charges, but in the hopes of gaining ownership of properties if the borrower failed to make the payments on it..."

To figure out just how much inflation in RE has been caused by the availability of mortgages, imagine what the average selling price of a home would be if no one could take out a mortgage to buy one. I'm not certain what that price would be, but I'm fairly confident that it would be a lot less than it is now.

I'm not sure what affect this would have on the supply side, but I suspect that there would be less speculative construction,as builders would want to be fairly certain they had a buyer for whatever homes they were building.

Patiently Waiting said...

Recently I learned how my great-grandmother bought a little house in New West before 1920.

She bought it by making payments directly to the guy who built it. Despite being a widow with children, as a lone woman and working in a sawmill, she was able to buy at that time. The reason? My great-grandfather was a Freemason and so was the builder.

I bet you a widow with children working in a blue collar job couldn't buy any house in New West today.

patriotz said...

imagine what the average selling price of a home would be if no one could take out a mortgage to buy one

Not hard to imagine, it would be based on the yield on the property, just like a bond. But the yield would be higher because of the higher risk.

In short - drum roll - it would be priced at about the same multiple of rent as it was in the 1950's, when almost everyone used mortgages to buy houses but wouldn't buy unless the monthly payments were about 20% less than renting the same place.

But you'd have a lot more people renting and a lot fewer owner-occupiers. Probably a lot of SFH would be owned by REIT's or similar vehicles so they could be financed by the capital markets without mortgages.

Unavailability of leverage does not change fundamentals, but it makes it a lot harder to speculate.

freako said...

"These daring insurance companies did it, not in the interest of making money through fees and interest charges, but in the hopes of gaining ownership of properties if the borrower failed to make the payments on it..."

This sounds like a conspiracy theory. A bit farfetched. My understanding is the the FHA introduced more borrower friendly mortgages in the 30's. The ownership rate prior to that was in the 20 percent range, almost inversed by now.

"Mortgages, while allowing people to purchase homes and live in them while paying for them, have a downside as well. They have caused RE prices to be inflated."

Perhaps. But there is absolutely nothing wrong with using debt to acquire assets. Most of us are paid in an income stream, so it only makes sense to match payments with it.

"Unavailability of leverage does not change fundamentals, but it makes it a lot harder to speculate. "

It makes it harder to buy in general. Ownership rate would plummet.


"Not hard to imagine, it would be based on the yield on the property, just like a bond. But the yield would be higher because of the higher risk."

Yes, the theoretical price should be the same whether there is leverage or not. There is a difference in who owns it (as the pool of potential owner's shrinks) but price would be expected to be similar.

Why is that? Because the size of the pool of potential asset holders does not change the underlying value. It takes only a few unrelated parties to create enough competition that prices reflect reasonable valuations.

If stock XYZ could only by owned by one eyed left handed people, it fundamental value would be unchanged. There may not be many one eyed left handed people in the world, but they judge assets no different than the aggregate population, so we'd expect similar valuations.

The same obviously holds true for housing. Mortgages do not increase underlying fundamentals, nor long run price levels. What they do allow is for increased levels of mispricings.

The idea that longer term mortgages will increase prices levels is equally flawed, for the same reasons.

patriotz said...

And so is the idea that rich foreign buyers, or whoever else is the alleged source of "dumb money" du jour, can cause a permanent disconnect between prices and fundamentals, I would think.

patriotz said...
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freako said...

"I learned this week that the holder of a variable rate mortgage does not have his payment increased automatically if rates rise to keep him on his amortization schedule."

So if rates change by 20% or so (say going from 5 to 6 percent), you are now neg am until renewal? I hope people are aware of that.

freako said...

And so is the idea that rich foreign buyers, or whoever else is the alleged source of "dumb money" du jour, can cause a permanent disconnect between prices and fundamentals, I would think.

Aboslutely. Honestly, (and I have railed against this many times in the past), but the arguments defending present RE prices are very very weak. Flawed generalizatons.

What astounds me is that there is absolutely nothing in the industry itself with the incentive or the ability to see the obivous from a fundamental asset valuation perspective.

And that is why:

1. The bubble is allowed to get ou t of control
2. Many of the people who see the obvious have a finance background.
3. These people are not part of mainstream (bloggers etc)

Information diseminatin aside, many of the actors themselves don't acto in their own self-interest. As I have stated many times, in the stock market, value investors who do due diligence sell (or short) when speculators move prices past justifiable levels. This helps to balance the market. The tech bubble was an exception, because the inflow of dumb money was so obscenely large, that there was nothing value investors could do.

The RE equivalent to value investor is the old school cash flow investors. The problem is that they have an asymmetric view because they don't acknowledge opportunity cost. Hence they don't buy when prices are high, but they also don't sell. There is nothing to clear the market. Builders build, of course, but that takes time. If nothing else balances the market, the builders eventually will. But should the psychology of the discretionary demand (owners and speculators) change it won't have to come to that.

Warren said...

The RE equivalent to value investor is the old school cash flow investors. The problem is that they have an asymmetric view because they don't acknowledge opportunity cost. Hence they don't buy when prices are high, but they also don't sell.

Good points, but don't you think an old school cash flow investor would sell a few properties now (lets say 25% of his/her holdings) and re-buy those properties plus more in the future downturn? If they are in it for the long haul they've seen and done this in previous boom/busts. Transaction costs are obviously a lot different with real estate compared to stocks, but I think the principles still apply. Why do you say they don't acknowledge opportunity cost?

casual observer said...

"This sounds like a conspiracy theory. A bit farfetched. My understanding is the the FHA introduced more borrower friendly mortgages in the 30's. The ownership rate prior to that was in the 20 percent range, almost inversed by now."

You are correct about the FHA, but they weren't the ones that started offering mortgages in the first place. Prior to the FHA initiatives, the ownership rate was more like 40%.

QUOTE FROM THE SAME ARTICLE: History of Mortgages

"It wasn't until 1934 that mortgages, as they work now, came into being. The Federal Housing Administration (FHA) played a critical role. In order to help pull the country out of its economic depression, the FHA initiated a new type of mortgage aimed at the folks who couldn't get mortgages under the existing programs. At that time, only four in 10 households owned homes. Mortgage loan terms were limited to 50 percent of the property's market value, and the repayment schedule was spread over three to five years and ended with a balloon payment. An 80 percent loan at that time meant your down payment was 80 percent -- not the amount you financed! With loan terms like that, it's no wonder that most Americans were renters."

"But there is absolutely nothing wrong with using debt to acquire assets."

I would say that makes sense as long as the asset is increasing in value, or likely to increase in value beyond the interest costs. Financing assets that are depreciating is a double edged sword. Trouble is, even though an asset is expected to appreciate, there are no guarantees. You take your chances.

"It makes it harder to buy in general. Ownership rate would plummet."

True, but I think prices would plummet as well.

" Mortgages do not increase underlying fundamentals, nor long run price levels. What they do allow is for increased levels of mispricings.

The idea that longer term mortgages will increase prices levels is equally flawed, for the same reasons."


Agree that the fundamentals don't change, but I don't know about the price levels. If your pool of potential buyers is increased by the availability of cheap mortgages, prices IMO will be higher.

freako said...

I would say that makes sense as long as the asset is increasing in value, or likely to increase in value beyond the interest costs. Financing assets that are depreciating is a double edged sword. Trouble is, even though an asset is expected to appreciate, there are no guarantees. You take your chances.

How about a car. It costs say $50,000. It will be used for 20 years, which using simple math means a cost of $2500 a year. Somebody who is paid by income stream would appreciate the opportunity to pay installments, else they would have to needlessly save for many years.

Don't forget that there are three components to a loan: Real interest rate, administration markup, and default risk markup. The real interest rate closely tracks inflation. In other words, the interest expense isn't all pissed away.

When you take a out a loan, the lender includes the cost of your OWN default risk. Hence you are basically paying for your own risk. In that sense, you lose either way (default or not). There are no guarantees, but if the asset you buy is riskier than your own default risk, market efficiency expects you to be ahead using leverage. That is why it makes sense to borrow and invest in risky assets such as real estate, but not to borrow money to put into a savings account.

True, but I think prices would plummet as well.

Probably in the short run while the market adjusts, but well heeled entities would compete to buy the assets if they fell below fundamental value. In fact, ownership could still be widespread as people bought equities which specialized in such ventures. There is no reason for prices to go to a permanently higher plateau because of access to leverage. The underlying equation has people competing for housing based on population growth and incomes. The breakdown between renting and owning does not change that. Though I'd expect the market to be more efficient as the majority of actors would be professionals who apply rigid financial analysis. Thus similar long run price levels, but fewer wild price swings. That would make sense as for the most part population growth and incomes are fairly predicable and slow moving beasts. The price and volume volatility we presently have is totally unnatural given the relatively low volatility of the fundamentals.

I think the whole notion that the only true limit to RE prices is access to leverage is absurd. It may seem that way in the short run, it simply doesn't work that way in the long run. If people don't come to their senses, builders will just keep building until we are at the "One wafer thin mint monsieur" moment.
link


Agree that the fundamentals don't change, but I don't know about the price levels. If your pool of potential buyers is increased by the availability of cheap mortgages, prices IMO will be higher.

So you didn't buy my inverse argument? That the long run value of a stock wouldn't be any different if it could only be owned by left handed one eye people? The chances of an asset with a smaller pool of buyers being temporarily overpriced is smaller, I agree. But it won't change long run valuations. Left handed one eyed people would be totally capable of properly pricing the company within their own cohort. It doesn't take many people competing for an asset to keep pricing in line. Public works contracts can have competitive pricing with as few as two sealed bids.

freako said...

Agree that the fundamentals don't change, but I don't know about the price levels. If your pool of potential buyers is increased by the availability of cheap mortgages, prices IMO will be higher.

Some more details on how markets would remain long run efficient.

If prices are higher than fundamentally justifiable (yield, expected growth in rents), there exists what we call an ownership premium. The flipside is that an owner's premium is a renter's discount. A renter's discount is a landlord's loss. I would not expect landlords to swallow these artificially low yields perpetually. Eventually, they would sell which would put more units on the market. Simultaneously, builders would keep building, as the opportunity cost of empty land is high. Since the ownership rate is already very high, there is a limited pool of owners left to buy. Furthermore, this pool have are financially weaker (one reason why they remain renters). Thus the extra supply will squeeze prices continously until they are back to the points that landlords are satisfied with the yield.

freako said...

Good points, but don't you think an old school cash flow investor would sell a few properties now (lets say 25% of his/her holdings) and re-buy those properties plus more in the future downturn?

Run this by Chipman. He will say that the numbers make sense, so he will keep the property. I don't think he is alone. This is how these people think. They chose RE as their vehicle for a reason. It is simple, and they can understand it. In general, it is not a bad strategy, and it has done well for many. However, these people are not equipped to understand or cope with rare events such as a bubble. All they think about is that they don't lose in the nomianl sense. This is true, of course. But far from optimal investing. The externality to the rest of the world is that they don't help keep the market efficient.

freako said...

Why do you say they don't acknowledge opportunity cost?


Frankly, I don't think they understand it. Much of residential RE is held by mom & pop investors. It is an extraordinarily simple view of the world, and that isn't a problem most of the time. Seriously, go run it by Chipman. He argued that he would keep his properties even if it WAS known with certainty that prices would fall 30%.

Warren said...

Frankly, I don't think they understand it. Much of residential RE is held by mom & pop investors. It is an extraordinarily simple view of the world, and that isn't a problem most of the time. Seriously, go run it by Chipman. He argued that he would keep his properties even if it WAS known with certainty that prices would fall 30%.

Well, its tough understanding the frame of mind of others, but you're probably right about mom & pop style investors. Other real estate investors probably operate the same as value stock market investors.

casual observer said...

"How about a car. It costs say $50,000. It will be used for 20 years, which using simple math means a cost of $2500 a year."

Using simple math and NO interest, this makes sense. But, if you add even a small amount of interest (say 5% per annum), and then financed it over 20 years, you're annual cost would be almost $4000 per year. Your $50k car just cost you $80k. And it is now worth $0 after 20 years. Add to this, the fact that cars depreciate very quickly, and you would be in a position of owing more than your vehicle is worth during most of the loan. Definitely not an asset in my opinion. Now I realize that people do not finance cars over 20 years (unless they add the cost of the car onto their mortgage), but your example used 20 years so I stuck with that.

Paying interest on a depreciating asset, IMO is not ideal. Vehicles are a drainers of wealth - you will always lose money (unless they are collectible), because their eventual value is zero. Knowing this, If I wanted a $50k car, I would rather lose the $50k, than $50k plus interest.

"Somebody who is paid by income stream would appreciate the opportunity to pay installments, else they would have to needlessly save for many years."

I'm sure they would appreciate it, judging by the amount of debt that people seem to carry nowadays. In this era of instant gratification, saving up for something seems to be so...yesterday.

"Don't forget that there are three components to a loan: Real interest rate, administration markup, and default risk markup. The real interest rate closely tracks inflation. In other words, the interest expense isn't all pissed away."

Yes, assuming an inflationary environment, some of that interest cost is eaten up by inflation. But, it is a cost that still has to be paid. I would much rather be earning interest, than paying interest.

"When you take a out a loan, the lender includes the cost of your OWN default risk. Hence you are basically paying for your own risk. In that sense, you lose either way (default or not)."

Agree.

"There are no guarantees, but if the asset you buy is riskier than your own default risk, market efficiency expects you to be ahead using leverage."

Leverage is an amplifier of risk/return. It is nice on the upside, not so nice on the downside. Nobody makes an investment expecting to lose money. The problem is that your "investment" can go down in value, but the debt does not, and the interest clock keeps ticking.

Just look at the options and futures markets. Those markets are highly leveraged and risky, yet I would say that the majority of individual investors who speculate in those markets, eventually lose their shirts. Even professionals get caught on the wrong side of a trade, now and then.

"Thus similar long run price levels, but fewer wild price swings. That would make sense as for the most part population growth and incomes are fairly predicable and slow moving beasts. The price and volume volatility we presently have is totally unnatural given the relatively low volatility of the fundamentals."

If that means that price levels today would be closer to what they were before the bubble, plus a small amount to account for income growth during the last few years, then I agree.

patriotz said...

Paying interest on a depreciating asset, IMO is not ideal. Vehicles are a drainers of wealth - you will always lose money (unless they are collectible), because their eventual value is zero

I'm sorry to sound rude, but you don't understand a thing about finance or even basic economics.

"Vehicles are drainers of wealth"??? Well then how in the world can anyone make money running a taxi or trucking business?

Read any writings on economics from Adam Smith on. Even Karl Marx got the picture better then you.

What you fail to understand is that capital has a yield - it produces income. This is the very reason why we are willing to pay interest to borrow money - people can use it to buy assets which yield income. Depreciation of an asset has to be subtracted from income of course - but the yield is still (or should I say ought to be) positive. If a business thinks it can get a higher yield on assets than the going interest rate, it will borrow money to buy them. That's how capital markets work.

Businesses can also raise capital by selling shares, but the shareholders will also expect a yield on their shares, the same as a lender expects a yield on his money. They just have different risk/return profiles.

Trouble is, even though an asset is expected to appreciate, there are no guarantees.

You're talking as though asset appreciation, when it occurs, is some kind of exogenous process, when in fact it's function of the income that the asset yields. The speculator's folly.

Why not read a bit about how bonds are priced, for starters, and move up from there.

freako said...

Your $50k car just cost you $80k. And it is now worth $0 after 20 years.

As I mentioned earlier, you need to take the time value of money into accountin order to get apples to apples comparison. The car did NOT cost you $80K in real terms if you financed it. That reminds me of some of those fallacious online "tips" that tell you that you will save x amount of "interest cost" if you increase your payments by y amount. I think PV calculations and compounding are some of the most abused concepts out there.

If interest rates were 5%, inflation was likely around 3%. Thus it cost you 2% a year to finance it.

And yes, the car is worth zero at the end, but it would have been worth zero if we had bought it cash as well. And if you include opportunity cost, it would have cost you about 3.5% (risk free) to own it.

The point is that if you needed the car, and don't have the means to buy it outright, you are truly better off using financing than not, interest expenses or not. The only difference between a financed and a cash purchase is the difference between opportunity cost and borrowing cost.

IMO is not ideal. Vehicles are a drainers of wealth - you will always lose money (unless they are collectible), because their eventual value is zero.

You can't make that determination. If the car is used for business purposes, it is a capital investment. Even if it isn't, nothing changes. You could make the same argument you made against a cash purchase of the car, or a good steak, or a bottle of beer.

I'm sure they would appreciate it, judging by the amount of debt that people seem to carry nowadays.

Sure debt can be abused, but that is another matter. I am assuming rational behavior.

But, it is a cost that still has to be paid. I would much rather be earning interest, than paying interest.


Yes, and I would rather have a million dollars than not. But one is either a net saver or a net borrower, depending on situation.

Actually, I take that yes back. If you effectively employ the borrowed money, you could be much better off paying interest. Why do you think corporations carry debt? Because there are more opportunities than there is cash. You cannot generalize about the intended use of the capital.

Those markets are highly leveraged and risky, yet I would say that the majority of individual investors who speculate in those markets, eventually lose their shirts.

To whom do they lose their shirts? It is a zero sum game. Those with physical exposure to say porkbellies pass on some risk, which is assumed by a speculator. Here you are generalizing against leverage. Yes, leverage amplifies risk-return. It does nothing to the underlying expected return.

In the case of RE investing, the leverage jacks up the risk, but it is still only comparable to unlevered equities (present situation exempted). Each of us has a personal risk preference. Leverage allows us to tweak it. And in the case of RE, to acquire it in our lifetime.

freako said...

Well, its tough understanding the frame of mind of others, but you're probably right about mom & pop style investors. Other real estate investors probably operate the same as value stock market investors.

The million dollar question is what makes up the majority of investors. My bet is that it is the opportunity cost challenged mom & pops. Otherwise, the bubble wouldn't have inflated as it did. Pricing is set at the margin, and if a sufficient number of the investment class bailed once valuations became ludicrous, there would have been more than ample supply to knock prices back to reality. But we have been grossly mispriced for 4+ years now.

casual observer said...

"Vehicles are drainers of wealth"??? Well then how in the world can anyone make money running a taxi or trucking business?"

I was not talking about vehicles used to generate income. Totally different scenario. I was talking about the average joe buying a vehicle for family use.

"You're talking as though asset appreciation, when it occurs, is some kind of exogenous process, when in fact it's function of the income that the asset yields. The speculator's folly."

Asset appreciation can occur for any number of reasons, including the one you mentioned. RE has appreciated substantially in the last few years, even though the income (rent) that it generates has not.

"I'm sorry to sound rude, but you don't understand a thing about finance or even basic economics... Why not read a bit about how bonds are priced, for starters, and move up from there."

Hey, whatever. I was talking about a person being better off paying cash for a depreciating consumer item (personal vehicle) as opposed to paying interest to finance it. You're talking about capital yields, and a person or business borrowing money to buy income generating assets. Apples to oranges IMO. Don't know why you felt the need to be condescending and insulting.

freako said...

RE has appreciated substantially in the last few years, even though the income (rent) that it generates has not.


And the null hypothesis is that it shouldn't have. If you use the exception to justify the exception, we are going in circles.

I was not talking about vehicles used to generate income. Totally different scenario. I was talking about the average joe buying a vehicle for family use.

The case of consumption of durables is not that different. An investment asset generates income into the future. A durable generates utility into the future. There is nothing wrong with matching the payments with the utility, especially given the fact that our incomes also come in streams for the most part.

We really use the car over a period of time, so why not pay for it over a period of time?

casual observer said...

"The car did NOT cost you $80K in real terms if you financed it."

Yes, but it still cost you $30k in finance charges that you could have saved, invested, or spent on something else.

"If you effectively employ the borrowed money, you could be much better off paying interest. Why do you think corporations carry debt? Because there are more opportunities than there is cash. You cannot generalize about the intended use of the capital."

I thought we were talking about a person buying a non-income producing vehicle for personal use.

If we're talking about a business utilizing borrowed capital in order to purchase or expand and increase its income generating capacity, that's a totally different scenario.

"The point is that if you needed the car, and don't have the means to buy it outright, you are truly better off using financing than not, interest expenses or not."

Of course. I was just saying that adding finance charges to the cost of a depreciating asset (car) is not ideal. When we started out, we didn't save up enough money until we could pay cash for a new car. We saved up and paid for a used one first, then kept saving what we would have spent on a car payment. After a few used cars, we eventually had enough to pay for a new one - cash.

"To whom do they lose their shirts? It is a zero sum game."

If one loses all his money speculating, it is a zero sum game for him - because that is what he has left (zero). The problem with leveraged speculating in high risk futures trading is that one can lose more money than what they've risked. The individual speculator will usually lose his shirt to the professional. Although, there have been a few high profile cases of professional traders losing huge sums of money by being on the wrong side of a trade (BMO - $680 million losses on natural gas trades).

"In the case of RE investing, the leverage jacks up the risk, but it is still only comparable to unlevered equities (present situation exempted). Each of us has a personal risk preference. Leverage allows us to tweak it. And in the case of RE, to acquire it in our lifetime."

Using leverage to purchase RE is much different (obviously) than futures speculating. There is an almost zero chance that a RE investment would lose all its value. OK, I guess if there was a nuclear war, or big earthquake, or a meteor hitting the area, then maybe the value might go to zero, but highly unlikely. Because it can be used to generate an income (in the case of a residential or commercial property), it will always be worth something, and under normal circumstances (no bubble) should appreciate more than enough to offset the interest costs.

casual observer said...
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casual observer said...

"A durable generates utility into the future. There is nothing wrong with matching the payments with the utility, especially given the fact that our incomes also come in streams for the most part."

I didn't say there was anything wrong with matching payments with the utility, I was only pointing out that this adds to the cost of the durable goods. The utility does not change, it only costs you more to obtain it if it's financed.

"We really use the car over a period of time, so why not pay for it over a period of time?"

Using this logic, are you saying that we would all be better off if we financed all of the consumer items that we use over a period of time - TV's, appliances, automobiles, furniture, clothes, etc.?

casual observer said...

"RE has appreciated substantially in the last few years, even though the income (rent) that it generates has not.


And the null hypothesis is that it shouldn't have. If you use the exception to justify the exception, we are going in circles."


RE is not the only asset class ever to appreciate in the absence of additional income generation. The shares of many companies appreciate in value all the time even for companies with no earnings. Now, one could say that the investors are speculating on the future earning capacity of those companies, but that doesn't change the fact that it does happen. Precious metals can appreciate in value, with no income being generated. My point is that RE is not the only exception.

freako said...

Yes, but it still cost you $30k in finance charges that you could have saved, invested, or spent on something else.

This is starting to get circular. What I am saying is that the $30K is in future dollars, hence less in todays dollars.
Otherwise, not apples to apples. As mentioned, it irks me when somebody mentiones that increasing your payments by 10% will save you $250,000 in interests charges. That neglect to mention that it is $250,000 in year 2032 dollars. Don't be that guy.


I thought we were talking about a person buying a non-income producing vehicle for personal use.

See previous post regarding future utility of durable consumables.

When we started out, we didn't save up enough money until we could pay cash for a new car.

That is one way of doing things. People are obviously free to play with their investment vs. consumption choices. If my current income allows me to pay for prorated car expenses, why should I have to wait until I have saved the entire amount. If I need a car now, I need a car now.

Because investments have real returns, on paper we are always better off saving now and consuming later. But what fun is it to save until you die? Again, that is getting off topic.

The problem with leveraged speculating in high risk futures trading is that one can lose more money than what they've risked

Your exposure is your exposure. And leverage works both ways. It is a problem if you lose, great if you win.

If one loses all his money speculating, it is a zero sum game for him - because that is what he has left (zero).

I presume that you know what a zero sum game is and are just being facetious.

The individual speculator will usually lose his shirt to the professional.

That may or may not be true. But it has little to do with the use of leverage, and more to do with no playing with sharks.

Using leverage to purchase RE is much different (obviously) than futures speculating. There is an almost zero chance that a RE investment would lose all its value.

Yes, it is different. But I think you need to tweak your view of what leverage in the futures market really means. You get huge exposure with little deposit. That does not mean that you HAVE to. Nor does it mean that you lose all your money. If I wanted to buy the S&P index for $100,000 exposure, I only need to put down $5K. I could put down more, but why bother since I don't have to. Think of the margin as a deposit rather than 100% of your investment. Maybe the other part of my investment is $95K in mutual funds. From a portfolio perspective, I am not dangerously levered. Also, realize that many of the underlying assets that have futures have very low volatility to begin with. Finally, futures are often used to hedge, thus it actually reduces risk. It seems to me as if you are zeroing in on futures to make a point about the dangers of leverage. If so, I don't agree. Leverage is what it is. It can be used appropriately, or abused. There is a reason why futures have high leverage. As mentioned, it is basically a deposit, as no physical assets change hands until settlement date.

freako said...

Now, one could say that the investors are speculating on the future earning capacity of those companies, but that doesn't change the fact that it does happen.

Yes that is exactly what happens. However, a little less clear how that would work for RE. A company may have a great product in the pipeline which has caused the stock to be bid up ahead of actual earnings.

I have a harder time believing that there are similar future expectations of the aggregate RE market.

casual observer said...

"This is starting to get circular. What I am saying is that the $30K is in future dollars, hence less in todays dollars."

I agree, it is starting to get circular, and I agree that the $30k is in future dollars.

"I presume that you know what a zero sum game is and are just being facetious."

You are correct. My feeble attempt at humor.

"If I wanted to buy the S&P index for $100,000 exposure, I only need to put down $5K. I could put down more, but why bother since I don't have to. Think of the margin as a deposit rather than 100% of your investment. Maybe the other part of my investment is $95K in mutual funds. From a portfolio perspective, I am not dangerously levered."

Agree for this example. I was talking hypotheticaly about the guy who only puts up the $5k and is levered for the other $95k, with no other investments. Not taking into account his entire portfolio. If his $100k levered investment drops by 10%, he's lost his original $5k, plus potentially another $5k.

"Also, realize that many of the underlying assets that have futures have very low volatility to begin with."

I had commodity futures in mind, somewhat more volatile than your S&P index example.

"I have a harder time believing that there are similar future expectations of the aggregate RE market."

I agree. I think that many people feel RE just always goes up in price, like its a law of nature or something.

freako said...

I had commodity futures in mind, somewhat more volatile than your S&P index example.

Hmm. Commodities really aren't that volatile for the most part.

Agree for this example. I was talking hypotheticaly about the guy who only puts up the $5k and is levered for the other $95k,

Ok, but what is the difference between a 5% down condo buyer losing his shirt and a speculator on copper futures losing his shirt. Real estate can't go to zero, but nor can copper. And both investors can sure go to zero and beyond.

I agree. I think that many people feel RE just always goes up in price, like its a law of nature or something.

At least there are a few things we agree upon. The problem with RE is that the market participants don't see it as we do, namely prices reacting to market fundamentals. They see prices increases by themselves as affirmation of a good investment. Won't last obviously.

Never before have so many paid so much with such little thought.

casual observer said...

"Ok, but what is the difference between a 5% down condo buyer losing his shirt and a speculator on copper futures losing his shirt. Real estate can't go to zero, but nor can copper. And both investors can sure go to zero and beyond."

True, copper can't go to zero, but the investment can. See example in previous post. In both cases, the investor ends up owing more than the asset is worth. In the case of the futures contract, when it comes time to settle, the investor loses his $5k plus another $5k. His investment lost more than what he initially invested. At least in the case of RE, there is no settlement date (unless one has to sell).

casual observer said...

"Never before have so many paid so much with such little thought."

How very true.

freako said...

"At least in the case of RE, there is no settlement date (unless one has to sell).
"

True, but our copper speculator could roll it over. That will take more cash of course. But what about the fact that our condo speculator is bleeding cash month in and month out. Conclusion: Both can hurt badly if poorly timed.

el bbub said...

I think itsthis kind of strategy casual observer was talking about.

freako said...

"I think itsthis kind of strategy casual observer was talking about. "

I read to about here:

"Since a car is a depreciating asset, the correct answer to the question, "How Much of Your Car Should You Finance?" then is zero. You can "afford" the car you can buy with cash. "


Then I stopped, because the above is complete bullsh*t. Your car is a durable, an asset that provides value into the future. There is absolutely no reason why you it has to be bought cash.

el bbub said...

freako

Don't you think it may highly depend on the nature of work one does? or even their definition of what value really is to them?

Cause by itself the only value its gonna bring you is a handful of rust.

So for a person who doesn't plan to make money driving around, buying a car and paying interest for it is not a good thing. Unless he really diggs the idea of cource.

nokem said...

Can I take this opportunity to ask a practical question, since these graphs do concern resets and so forth.

Say you have a 400,000 mortgage at 5.1 percent with a five year term. Fixed rate.

In five years rates are at 6 percent. Does the payment get calculated only on the remaining principal or do they get you somehow?

casual observer said...

"In five years rates are at 6 percent. Does the payment get calculated only on the remaining principal or do they get you somehow?"

The payment at renewal is calculated using the remaining principal balance, the prevaling interest rate, payment frequency (monthly, bi-weekly, etc.), and the remaining amortization.

freako said...

"So for a person who doesn't plan to make money driving around, buying a car and paying interest for it is not a good thing."

That is not for you or Jensen to judge. You might as well tell people that it is fiscally irresponsible to the movies.

I don't know why the "paying interest" part gets everyone into a tizzy. Reminds me of the "why pay your landlord's mortgage" cliche.

Imagine that you are a doctor who just finished your internship and are now earning REAL money for the first time in your life (after years of living like a student pauper). The 1976 Gremlin doesn't cut it anymore, so you need new wheels.

So far, you have only saved $3,000. The car you want (and can afford) costs $60,000. Should you wait and continue living like a pauper to save for this car.

Hell no. If the car is good for 10 years with a residual value of $10K, it cost you $6K per year. You already determined that you can afford that, so what is the problem?

The interest charges? Give me a break? First of all, don't forget the time value of money. You are paying back with inflated money. Your $800 car payment in 2016 is not really an $800 car payment.

Second, what is the difference if you bought it cash? You would still incur an opportunity cost. Since we can get 4% at ING, the car is costing $2400 a year in foregone interest. If I had financed it, it'd cost perhaps another 50%, due to spread.

Seriously, the financing part is not that relevant. If you can afford the car based on your income stream, you can afford it. I think Jansen knows better, he is just preaching to his converted flock of fiscal uber conservatives. Anyhow, it is a gross gross oversimplification that insults peoples intelligence. Being financially responsible has nothing to do with following arbitrary rules such as this one.

el bbub said...

freako

I'm actually not against financing at all. When it makes sense it makes sense to go with it. But there's always the opposite.

I, myself, don't even have a car and I don't think I'm really missing out on the opportunity to fill up for 60 bucks a tank, paying insurance and interest for something I don't use to generate income with.

Is there a situation when you wouldn't wanna finance something? not including hight interest or affordability issue cases of course.

freako said...

"Is there a situation when you wouldn't wanna finance something? not including hight interest or affordability issue cases of course. "

Financing is bit like guns. You can get hurt if you don't handle it propertly. That is no reason to ban guns, nor financing.

Without financing, you cannot get into debt over your head. Of course, you could still fritter your money away on needless things.

Again, the key is that a car (or similar item) is consumed over long periods of time. Therefore, there is nothing wrong with paying for it over time.

You could apply "if you can't buy it outright, you can't afford it" to almost anything. Rent is consumed over time. A gym membership is consumed over time. Should you be required to put down a 10 year prepayment before you can "afford" to work out? Of course not. The same applies to the car.

Again, the fear of interest charges is partially misguided. If you buy the car outright, you are pissing away the return that money would have earned if invested? So what is the difference?

In summary, there are no real rules. Don't buy stuff you can't afford. If you spend money now, you will have less tomorrow. The tradeoff between consumption now and tomorrow is a personal one. Me, I think the optimal strategy is to smooth consumption over your lifetime. That way you get the most bang for your buck. Which is better?

1. Eating a huge bag of candy today.
2. Saving the bag until next week and eating it all then.
3. Eating a little bit of candy every day.

I vote for 3.

el bbub said...

freako

You presented some interesting parallels, kind of reminded me of Freakonomics book.

Funny, but, in the candy example I'd actually go with number 2, this way my body would burn off all glucose in muscle and start braking down fat while in ketosis. Then next week I eat that bag of candy to replenish my muscle glucose stores. This way I don't have to work extra hard everyday to burn off those extra calories of candy that I would've eaten if I went with number 3.

btw, that bag of candy can't be thaaat huge, cause it'd be the same as having a mortgage you can't afford!