REAL ESTATE CASE STUDIES
Welcome Back to Economics 101: Real Mortgage Rates
As the school year begins for many, and Labor Day marks the beginning of the second best season in NYC, I thought I would share a little economics lesson.
Perhaps you remember the concept of real vs. nominal interest rates from your college or business school econ class (or in this nerd’s case, junior year of high school). It is basically idea that you borrow money today, which because of inflation is worth less and less each year as you pay back your loan. The bank charges you an interest rate knowing this, which is called the nominal interest rate (this is the rate they quote you or that you see in the paper or on CNBC). But what you really pay back is the real interest rate, or the nominal rate minus the inflation – the measure of the declining value of the dollar.
Today’s mortgage rates are 4.5% for a 30 year fixed rate loan (both conforming loans and jumbo loans are the same rate today – see below). According to Uncle Sam, the current inflation rate is 2.0% , making the real interest rate on these loans just 2.5%. Sounds good, right?
Well, Uncle Sam also wants you to buy a home and has done a number of things to keep these rates down, from sponsoring Fannie Mae and Freddie Mac, to the Fed
buying lots of government and other bonds to keep interest rates low in general. More so, he also gives you a generous tax deduction on your mortgage – as do your state and local governments. In a place like NYC, where the average homebuyer pays between 35-45% in income taxes to various levels of government, this means that that 4.5% interest rate is actually reduced by that amount. So taking 40% income tax rates for this example, the rate you are actually paying is 2.7%, which when reduced by reported inflation means your real rate is just 0.70%.
Sounds even better, no? Well, it actually gets better. See, the reported figure for inflation by the government of 2.0% is viewed by many economists as being understated. Why would the government understate this figure? It’s because increases in annual spend for the largest part of the budget – an area called entitlements (aka untouchables) like Social Security, Medicare, etc. are determined annually by a thing called COLA (cost of living adjustment) = reported inflation (government employee income is also adjusted annually in this way). So if it is akin to political suicide to enact, or let alone propose, any changes to benefit levels for these programs, why not use “economics” to do it for you? Long story short, this means that most economists believe that real inflation is 3-4% or more! (As a gut check, how much more are your day to day expenses today vs. last year? I doubt you will say 2%).
So let’s plug 3.5% inflation into our formula for calculating real interest rate. The 30-yr mortgage rate of 4.5% minus tax benefit gets us 2.7% minus this actual inflation rate = -0.8%! YES – negative interest rate. What does this mean? You are actually being paid to take out a mortgage and buy a home, to the tune of nearly 1% per year. So in an environment where the bank may pay you 1% on a CD, you are getting paid about the same to borrow money to buy your own home. So, that’s really better! Almost too good to be true! And you know what your grandmother told you about things that are too good to be true – that they are! Well, in this case the reality is that at least for now it is true and you can take advantage of this! But, these situations don’t tend to last for long, so hit me up if you want to chat about it soon.
Wishing you a great Labor Day and Fall Semester!
