Why low mortgage rates are supressing borrowing
November 01, 2011
Would you make an investment that was guaranteed to lose money?
Probably not. So maybe you can understand why low interest rates, rather than stimulating borrowing, may actually be suppressing it.
Low interest rates are supposed to encourage borrowing. After all, from the borrower's perspective, the lower the interest rate, the better. However, current interest rates are so low that they don't provide lenders with much incentive to make loans. A comparison between current mortgage rates and inflation helps illustrate this problem.
Current mortgage rates have slipped below inflation
According to the Bureau of Labor Statistics, inflation for the past year was 3.9 percent. That's nearly as high as current 30-year mortgage rates, and significantly higher than 15-year mortgage rates, which are at 3.38 percent.
To a lender, that means the combined principal and interest they would be paid on a 15-year mortgage would be worth less, after inflation, than the value of the original loan. When you add to that the costs of administering a loan, and the possibility of having some borrowers default, it becomes pretty clear that lenders don't have much incentive in this environment.
From the standpoint of the borrower, it's easy to see why low interest rates would be attractive. However, it takes two parties to complete a loan, and interest rates that are below the rate of inflation are a powerful disincentive for lenders. This is a problem because the economy is sluggish, and part of the cause is that loans are hard to come by.
It may go against conventional wisdom, but higher interest rates could actually be good for the economy. They would encourage lenders to be more forthcoming, and put income back in the pockets of people with savings accounts and other interest-bearing deposits.
Historically, low interest rates have been used by the Federal Reserve to stimulate the economy. Since that tactic is clearly not working now, perhaps the current situation is just too different from past experiences. Under those circumstances, it may be that what is needed from the Fed is less historical perspective, and more original thinking.