Why do home buyers today think that mortgages are more affordable today than they were three or four decades ago? Tim Harford, the FT ‘undercover economist’, explains.
[C]ontrast today’s low-inflation economies with the high inflation of the 1970s and 1980s. Back then, paying off your mortgage was a sprint: a few years during which prices and wages were increasing in double digits, while you struggled with mortgage rates of 10 per cent and more. After five years of that, inflation had eroded the value of the debt and mortgage repayments shrank dramatically in real terms.
Today, a mortgage is a marathon. Interest rates are low, so repayments seem affordable. Yet with inflation low and wages stagnant, they’ll never become more affordable. Low inflation means that a 30-year mortgage really is a 30-year mortgage rather than five years of hell followed by an extended payment holiday. The previous generation’s rules of thumb no longer apply.
Because you are a sophisticated reader of the Financial Times you have, no doubt, figured all this out for yourself. Most house buyers have not. Nor are they being warned.
Tim Harford, “Why a house-price bubble means trouble“, Financial Times, 22 November 20014 (metered paywall).
Nominal interest rates were, indeed, high in the 1970s and 1980s, but inflation was also high. The result was low and sometimes negative real interest rates (the rate of interest minus the rate of price inflation). Borrowers’ positive reaction to low nominal rates of interest, disregarding price inflation, is an example of ‘money illusion’, although Mr Harford does not use the term.
This reasoning, by the way, applies to all debt – including student loans and credit card debt, not just mortgage debt.