Tuesday, October 12, 2010

The Absurdity of the Zero Interest Mortgage Meme

MSN quotes this gem of an article, speculating on the home mortgage interest rate in America. The unknown author thinks that the interest rate has a good chance of hitting zero percent. He reasons, "0% financing has long worked as an incentive in the auto industry." And, "After all, two years ago, few people would have thought a 4% mortgage was possible, Larson said."

The author ignores the fundamentals of bank financing. For home owners, their payment consists of two parts: principal and interest. If the sum of principal and interest is within his means, the home owner can afford the house. The laws of supply and demand says that the monthly payment of the average house will be affordable to the average home owner. Interest rate is but half of the price here, the other being home price. If there is excess inventory on the market, the sellers will have to lower the monthly payment to move inventory, meaning lowering both interest and principal.

The other market here is the financing market, being the bank. Banks do not care about the price of the monthly payment, per se. They only care about the interest payment. With a zero interest mortgage, the banks will lose money. With positive inflation, the interest rate has to be higher than inflation. With zero or negative inflation, keeping money in the bank is worth more than taking on the risk of lending. If we ever do get to a deflationary economy, banks will never incur a loss from mortgage lending. They will either not lend at all, or they will milk a government subsidy to cover their risk of lending.

In addition, in a deflationary period, by definition the home price will go down with the rest of the economy. With a lower home price, once again the monthly payment is within reach of the average buyer, all without having to resort to zero interest.

The author seems desperate to believe home prices will not fall. That desperation, and the political will to prop up the home prices, is harming all Americans and holding back our economic recovery.

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