Personal Finance & Money Asked on July 30, 2021
Please bear with my limited knowledge of monetary systems. I’ve got degrees in Comp Sci and Math, and i work as an ml engineer, so I’m pretty used to numbers. But, i simply can’t wrap my mind around the logic of our financial system. Is there someone out there who can help me understand whats going on?
Situation :
One can take up a loan at 1% interest rate to buy a house. (In Denmark, 2-3% in the US )
Question :
Why would anyone want to lend money at such a low interest rate?
Looking at price changes over the past 10 years, inflation is somewhere in the range 5-8% per year. I know there is something called CPI which claims inflation to be at 2% per year, but there seems to be little correlation between the CPI index and actual observed inflation.
So, i can get a loan, then buy assets with the loan, and quite rapidly inflation has eroded away the debt that i owe. And I am left with assets essentially bought to me by whoever lend me the money in the first place..
So whoever is giving me this loan is essentially giving me lots and lots of money. Why would they do this? Who is it? It doesn’t make any sense to me.. When inflation is this high, the only logical thing would be for interest rates on loans to also be high?
Clarification: The 5-8% inflation is just a ballpark number i came up with. I live in a big city, and the price on everything from coffee to homes has increased in the range 50 to 200% over the past 11 years. My questions are: Are interest rates this low because lot’s of investors with money want to lend their money, so when borrowing money i can get a good low rate. Or is there something else making the interest rate low? Who is it that gives the money in exchange for getting it back X years later plus 1-3% interest per year?
Starting with your first question, why would anyone want to lend money at such a low interest rate?:
Look at the loan as an investment Any investment has a risk/return profile. Getting higher returns generally requires taking more risks. Safer investments, where you are less likely to lose your money, return less. Lenders are willing to loan money at a low rate because there is very little risk of loss.
You list a 1% rate on a mortgage as an example. Not every borrower will be offered that rate. There are two big factors that affect the lender's risk for a mortgage loan: the borrower and the mortgaged property.
You also ask who is buying all the debt?. Speaking more generally than just mortgage debt, yes, some of it is bought by regular investors in the form of bonds, and bond funds and ETFs. Larger financial institutions, too.
The return is less than what you would see investing in other assets (e.g. stocks), but so is the risk. In theory, a loan is only given out to someone who is likely to repay it, and the interest charged is based on how likely they are to repay it (and to repay on time), so that the effect is that you are nearly guaranteed not to lose money, and to earn some small amount in interest (although it is still possible you will gain nothing, or even lose a bit). In practice, however, things like the mortgage/housing crisis we saw about a dozen years ago happen because those assumptions are not always true.
Answered by yoozer8 on July 30, 2021
Those low interest rate home loans are tied in with the fixed income markets. In that context the question is not so much "how does my 30-year home loan have an interest rate lower than inflation" as much as it is "how does my 30-year home loan interest rate compare to the interest rates of other fixed income products". For 30-year US home loans that often means comparing with 10-year treasuries.
So who is buying? Anyone can see the appeal of fixed income, but pension funds are a perennial customer, due in no small part to the tendency for Mortgage Backed Securities to have low correlation with the Equities. Another big investor is Freddie Mac--they reported over $2T in mortgage loans on their books in their last annual report, mostly loans against single family housing. Fannie Mae likewise.
A US lender might keep that home loan promissory note on their books, or they may sell it to an investor on the Secondary Market (often securitized in some way), but ultimately there is an investor comparing the interest rate, expected effects of prepayment, probability of default, and loss severity for that home loan against other fixed income products.
The US fixed income market is the largest, but EU is #2, and much of the same reasoning applies to that Denmark home loan example as to the US home loan example. Investors look at those home loan promissory notes and associated securities as just another type of fixed income. An investor expects a return sufficiently above the perceived "risk free rate" for fixed income of a similar expected maturity (10-year Treasuries say) to make the home loan worth those extra risks, but that rate could very well be lower than recent Consumer Price Index increases and still work as an investment.
Answered by C8H10N4O2 on July 30, 2021
To a large extent, central banks. In order to stimulate economies, the central banks are lending out money at interest rates that are well below the rate of inflation.
If you are a bank, and you can borrow money from the central bank at 0.1%, and then lend it to a house buyer for 1.0%, then you're making a profit.
Answered by Simon B on July 30, 2021
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