Borrowing: Home loans

The desire to own your own little piece of this world is ingrained deep into the human consciousness and it is therefore no surprise that buying a home is such a major landmark in life. Homes are pretty expensive though and it used to be that people had to save for many years before they could take out an affordable mortgage. Now, however, the game has changed and home loans have become so cheap and loose that someone with a reasonable income can take out a mortgage for the entire purchasing price without having to save anything at all.

As shown in the chart below, 30 year fixed mortgage rates in the US have fallen tremendously over the past two decades and monthly loan payments at today’s rates are close to half what they were in 1990.

The average American spends about a quarter of his/her disposable income on mortgage payments so it should be pretty obvious that halving the effective monthly payment would make homes affordable to many more people. The resulting sharp rise in demand then inflates prices as people bid each other up and a housing bubble is a fairly obvious result.

Within this environment of historically low interest rates, it is very hard to remain rational about home ownership, but you should really do your very best to keep your head – both for your own sake and for the sake of our economy. Firstly, you have to ensure that your mortgage is actually an investment loan and not a consumer or speculation loan as discussed earlier. For this, you have to fulfill two criteria:

  • It must be less expensive to buy than to rent. This implies that interest expenses must be lower than the rent you would pay for a similar sized home.
  • You must have the honest intention of living in this home for many years (avoid the unethical practice of buying homes for the purpose of speculation).

Secondly, you have to be sure that you can honestly afford the home and that you would still be able to honor your repayment contract if circumstances change. Here we have three criteria:

  • You must still be financially secure after the initial down-payment. This implies that you will have the financial resilience to absorb any unforeseen economic circumstances.
  • You must be able to accommodate the new monthly loan repayments without having to change your lifestyle at all.
  • If you have an adjustable rate mortgage, you must honestly be able to handle a doubling of interest rates.

These criteria will probably mean that you will have to wait a few years longer than you otherwise would, but there really is a very good reason for this more reserved approach: the fact that the fundamental assumption that makes home loans very attractive; that the economy will grow forever,  is very likely to become invalid within this decade (especially in the developed world). And yes, just like the fixed dollar monthly payment promised by a 30 year fixed mortgage becomes very attractive when salaries and home prices are increasing, it becomes very unattractive when when salaries and home prices are decreasing. You really don’t want to be stuck with a big home loan in a shrinking economy…

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