The Federal Reserve Bank of St. Louis caught my eye with a tweet the other day: “If you would know the value of money, go and try to borrow some.” This quote from Benjamin Franklin got me thinking about the cost of money and how it impacts a few different aspects of financial life. The St. Louis Fed was looking at what it costs the unbanked to borrow their next paycheck, but it is instructive to look at interest rates as they relate to things like the pensions and housing, too.
Despite ten years of stock market gains, many pensions are underfunded. Much of the blame has gone to retirement systems overpromising unrealistic payouts. Their assets haven’t returned as much as expected, providing a double whammy. The investment research guy in me wants to dig into the underlying investments and asset allocation. Many pensions got hurt by stocks during the financial crisis and reacted by allocating more to expensive alternative assets which have not performed well over the last decade.
The untold culprit of the pension crisis, however, is low rates. In the end, a pension scheme is just a math problem. The pension knows it owes $x each year for however many years the actuaries calculate. The beauty of the system is that just because you owe Jon Smith $30,000 a year for the next 30 years doesn’t mean you have to have $900,000 set aside in your pension account. If a 10-year Treasury yields 6%, you’d only need to own $500,000 of Treasurys to provide Jon Smith his $30,000. The problem is that today, the 10-year yields 2.58%. Pension systems are facing a strong headwind as long as rates are so low. Jake of Econompic breaks it down better here.
In this case, cheap money hinders pensions’ ability to provide what they’ve promised. Their money today buys fewer future dollars to offset their liabilities. Low rates mean there’s less room for error on the investment side, especially unforced errors like investing in expensive assets.
Depending on your source, Millenials either don’t want to buy houses or can’t afford to buy houses. It’s true that real estate in San Francisco, New York, or Miami is incredibly expensive (from this Clevelander’s perspective, anyway). However, historically, mortgages are cheap. The average 30-year mortgage rate in 1981 was 16.6% according to Freddie Mac. The long-term average mortgage rate is about 8%, but home buyers could have locked in a mortgage as low as 3.3% in 2012. That’s practically free! Houses cost more, but borrowing for a home costs less. Maybe this is less of a crisis and more of a shift in who’s getting paid in real estate transactions. It requires math to understand the cost of interest payments to a bank, but the sale price of a home is a much more accessible measure of cost. The sticker shock is immediate rather than spread out over 30 years so maybe that’s why we’re hearing so much about it now.
If we compare mortgage numbers on mortgagecalculator.org, a 30 year mortgage on a $300,000 home with a 20% down payment (so borrowing $240,000), not including property tax, insurance, etc has a very different total price tag depending on the mortgage rate. At 4%, the total payments come out to about $413,000, but at 16% it’s $1.16 million. At 16%, a total cost of $413,000 buys about $107,000 of house. At 4%, $1.16 million in payments buys $845,000 of house. How about inflation? $300,000 in 1981 has the same buying power as $876,000 today, after inflation. $100,000 in 1981 has the same buying power as $292,000 today. It’s interesting that these just about line up with the total costs for both rate regimes. Does this mean that a $107,000 house in 1981 is equivalent to a $300,000 house today or that a $300,000 house in 1981 would be like buying an $845,000 home today? No. I just think it’s worth digging a little deeper than headlines, especially on a subject with as many moving parts as home ownership.
As for Millenials, there are also sources that say that they have been the largest home buying cohort for the last five years so maybe the housing crisis is just a big crock of guac.
So Money is Super-Cheap Now?
For home buyers and investors, yes. For people who don’t have a bank account (the unbanked), money is incredibly expensive. Borrowing from a payday lender to make ends meet can cost upwards of 600%, depending on the state. The law requires payday lenders to disclose this both as a fee and as an annual percentage rate, but who reads the fine print to find the APR? The average fee for a typical $375 loan is $55, an APR of 382%. The rate is so high because the duration of the loan is only two weeks. This wouldn’t be such a big deal, but 80% of payday loans get rolled over. On the one hand, payday loans are taking advantage of the people least likely to be able to repay. On the other, this is the only lending source available to many of these people. There has to be a better way to lend to the unbanked, right?