Fiat currency and fractional reserve banking

[Haroki]

Quote from thenewguy:

I'm not sure I'm understanding this, but when you say the loan payment amount is %6, do you mean he's being charged %6 interest annually on the loan?

If that's true then he's losing %3 every year on that money.

I think the basic model of banks is that they charge a slightly higher interest rate than inflation, no?

TNG

I need help with this, so let's think this through using your previous 100k house. We also need a financial calculator to do this right, but let's try to be as accurate as we can.

Right 6% interest.

The problem I have getting my head around, is the 6% interest is set, and so is the principal. So the payment to the bank never changes, correct? But IF one gets COL increases that keep track with inflation - say 3% - does that mean that after the 2nd year, is the bank realizing, in effect zero interest, because the dollar that it is receiving after that 2nd year is now devalued by 2 yrs x 3%=6%?

Another way of thinking about it -

1- after tax net income is 40k
2-house payment - which will never change - is 500.
3-I get a COL increase that macthes the inflation rate of 3%

ok, so the 1st year, my payment is 6k, or 15% of my net. 6k/40k..
2nd year payment is still 6k, but now it's14.5%. 6k/41.2k
3rd year it's 14.1%. 6k/42.4k
4th - 13.7%. 6k/43.7
etc.

So from MY prespective, I'm giving them less and less of my net income, due to the devaluation of my dollar, but offset by my wage increase. Wouldn't the reverse be true for them? They begin to lose money every year after the 2nd since 3% is compounded annually?

 

[thenewguy]

Quote from Haroki:

I need help with this, so let's think this through using your previous 100k house. We also need a financial calculator to do this right, but let's try to be as accurate as we can.

Right 6% interest.

The problem I have getting my head around, is the 6% interest is set, and so is the principal. So the payment to the bank never changes, correct? But IF one gets COL increases that keep track with inflation - say 3% - does that mean that after the 2nd year, is the bank realizing, in effect zero interest, because the dollar that it is receiving after that 2nd year is now devalued by 2 yrs x 3%=6%?

Another way of thinking about it -

1- after tax net income is 40k
2-house payment - which will never change - is 500.
3-I get a COL increase that macthes the inflation rate of 3%

ok, so the 1st year, my payment is 6k, or 15% of my net. 6k/40k..
2nd year payment is still 6k, but now it's14.5%. 6k/41.2k
3rd year it's 14.1%. 6k/42.4k
4th - 13.7%. 6k/43.7
etc.

So from MY prespective, I'm giving them less and less of my net income, due to the devaluation of my dollar, but offset by my wage increase. Wouldn't the reverse be true for them? They begin to lose money every year after the 2nd since 3% is compounded annually?

I think this may be overcomplicating things...

The amount of money you owe each year increases by %6, but your salary only increases by %3. I believe the %6 refers to interest charged on the remaining principle, no? So whatever amount you owe total at the end of each year increases by %6, beating the COL increase.

TNG

 

[trefoil]

No, the amount you owe decreases with each payment, which includes a little bit of principal. In the first year, this is very low, but it increases each year.
The bank gets its interest up front, and I believe the majority of the interest on a 30 year mortgage is actually paid in the first 10 years.
The inflation advantage to owning a house is that the mortgage is fixed on a standard 30 year deal, unlike renting, where the rent goes up every year. So as your salary increases, the burden of the mortgage goes down slowly, until at the end you could probably pay off the remainder in advance and rid yourself of the debt.
The amount I pay for everything, mortgage, taxes, and insurance, is less than what I would be paying today if I were renting my old house, even without throwing in the advantage that US homebuyers have of the mortgage interest deduction. This is because the mortgage has stayed the same while of course inflation has continued on.
Also, if real estate prices are advancing, and you put down only 20%, or even just 10% of the price, then of course leverage works with you and all your house price has to do is go up by the percentage of the amount that you put in as your down payment for you to double your money. If the house price doubles, you have a return of either five or 10 times the amount you actually put in, net the interest and the transaction cost of selling, of course.
For most people - at least those who would have bought before the recent bubble - this is a great deal, since generally the pattern is you buy while you're working, pay it off, sell it to go retire someplace else, and you're able to use the profit to buy the retirement house while banking the initial equity. As my parents, who rented their entire lives, ruefully observed, everyone they knew who was well off in retirement had bought the houses they had lived in during their working lives, and bought their retirement home on the profit from the sale of it.
My own house, which I bought in 1999, has doubled, if you believe the most recent appraisal. I figure I'm doing well if I can just get 50% more than what I paid, which even today is doable. I can pay the transaction costs from the paid-in equity, and keep the profit, if I so choose.

 

[Wayne Gibbous]

I know a guy paid good money for a Fiat. Worst car ever made.

Makes a Yugo seem like a Lexus...

 

[Haroki]

Quote from trefoil:

No, the amount you owe decreases with each payment, which includes a little bit of principal. In the first year, this is very low, but it increases each year.
The bank gets its interest up front, and I believe the majority of the interest on a 30 year mortgage is actually paid in the first 10 years.
The inflation advantage to owning a house is that the mortgage is fixed on a standard 30 year deal, unlike renting, where the rent goes up every year. So as your salary increases, the burden of the mortgage goes down slowly, until at the end you could probably pay off the remainder in advance and rid yourself of the debt.
The amount I pay for everything, mortgage, taxes, and insurance, is less than what I would be paying today if I were renting my old house, even without throwing in the advantage that US homebuyers have of the mortgage interest deduction. This is because the mortgage has stayed the same while of course inflation has continued on.
Also, if real estate prices are advancing, and you put down only 20%, or even just 10% of the price, then of course leverage works with you and all your house price has to do is go up by the percentage of the amount that you put in as your down payment for you to double your money. If the house price doubles, you have a return of either five or 10 times the amount you actually put in, net the interest and the transaction cost of selling, of course.
For most people - at least those who would have bought before the recent bubble - this is a great deal, since generally the pattern is you buy while you're working, pay it off, sell it to go retire someplace else, and you're able to use the profit to buy the retirement house while banking the initial equity. As my parents, who rented their entire lives, ruefully observed, everyone they knew who was well off in retirement had bought the houses they had lived in during their working lives, and bought their retirement home on the profit from the sale of it.
My own house, which I bought in 1999, has doubled, if you believe the most recent appraisal. I figure I'm doing well if I can just get 50% more than what I paid, which even today is doable. I can pay the transaction costs from the paid-in equity, and keep the profit, if I so choose.

I guess this is what you mean by "yep"... LOL..
Thx for the reply.

So thenewguy, he mentioned something I didn't, paying down the principal. In reality, my example should have said that the payment is say, $515.

I think what you're missing is that the interest is paid off each month, it never accumulates-

100k x 6% = 6000..... 6k/12 =500.... So the total interest for the first month would have been $500, and that's been paid off to zero. Next month, the interest would be $499.50 or something similar, and so on and so on.

Do you now understand the value of the devaluation of the dollar for a person with a long term, fixed payment debt?

And so I guess my answer still remains, and something I THINK trefoil answered - does the bank actually LOSE money after the 2nd year?

 

[thenewguy]

Quote from trefoil:

No, the amount you owe decreases with each payment, which includes a little bit of principal. In the first year, this is very low, but it increases each year.
The bank gets its interest up front, and I believe the majority of the interest on a 30 year mortgage is actually paid in the first 10 years.

How is the interest on a mortgage generally calculated? I assumed it was simple interest, calculated on the amount of the principle remaining each year.

TNG

The inflation advantage to owning a house is that the mortgage is fixed on a standard 30 year deal, unlike renting, where the rent goes up every year. So as your salary increases, the burden of the mortgage goes down slowly, until at the end you could probably pay off the remainder in advance and rid yourself of the debt.
The amount I pay for everything, mortgage, taxes, and insurance, is less than what I would be paying today if I were renting my old house, even without throwing in the advantage that US homebuyers have of the mortgage interest deduction. This is because the mortgage has stayed the same while of course inflation has continued on.
Also, if real estate prices are advancing, and you put down only 20%, or even just 10% of the price, then of course leverage works with you and all your house price has to do is go up by the percentage of the amount that you put in as your down payment for you to double your money. If the house price doubles, you have a return of either five or 10 times the amount you actually put in, net the interest and the transaction cost of selling, of course.
For most people - at least those who would have bought before the recent bubble - this is a great deal, since generally the pattern is you buy while you're working, pay it off, sell it to go retire someplace else, and you're able to use the profit to buy the retirement house while banking the initial equity. As my parents, who rented their entire lives, ruefully observed, everyone they knew who was well off in retirement had bought the houses they had lived in during their working lives, and bought their retirement home on the profit from the sale of it.
My own house, which I bought in 1999, has doubled, if you believe the most recent appraisal. I figure I'm doing well if I can just get 50% more than what I paid, which even today is doable. I can pay the transaction costs from the paid-in equity, and keep the profit, if I so choose.

 

[Smart Money]

Quote from Haroki:

I guess this is what you mean by "yep"... LOL..
Thx for the reply.

So thenewguy, he mentioned something I didn't, paying down the principal. In reality, my example should have said that the payment is say, $515.

I think what you're missing is that the interest is paid off each month, it never accumulates-

100k x 6% = 6000..... 6k/12 =500.... So the total interest for the first month would have been $500, and that's been paid off to zero. Next month, the interest would be $499.50 or something similar, and so on and so on.

Do you now understand the value of the devaluation of the dollar for a person with a long term, fixed payment debt?

And so I guess my answer still remains, and something I THINK trefoil answered - does the bank actually LOSE money after the 2nd year?

I always thought of it as a pass-through. You are paying 6% on the outstanding principal. The bank takes that money, and then turns around and pays another entity 4% on that money, so they get to keep the difference of 2%. But that "other entity" that loans them the money creates it out of thin air.

Am I wrong?

SM

 

[Smart Money]

Quote from thenewguy:

How is the interest on a mortgage generally calculated? I assumed it was simple interest, calculated on the amount of the principle remaining each year.

TNG

That sounds right. And if you make a level payment every month, the amount of time that it will take to pay it off is different depending on how much you pay. So the amortization schedules are effectively a computation of what size payment you would need to make for it to take exactly 30 years, or 15 years, etc. to pay it off (for a set interest rate).

SM

 

[thenewguy]

Quote from trefoil:

No, the amount you owe decreases with each payment, which includes a little bit of principal. In the first year, this is very low, but it increases each year.
The bank gets its interest up front, and I believe the majority of the interest on a 30 year mortgage is actually paid in the first 10 years.

I understand the amount owing decreases with each payment.

If I'm correct, and it's a simple interest calculation calculated annually the math looks like this:

100k = principle
.06 a year is 6k (on the first year)
6k over thirty years is 92k (when you consider the declining principle)

Your salary may increase %3 a year, but you're still paying %6 a year for the remaining money, no matter how you slice it.

So while your principle and amount of interest owing is always decreasing, the total amount you pay in the end is always the same. That also means that for a 100k house, you're paying 192k. You'd need your house to almost double, just to break even then.

Now, don't get me wrong, I'm not arguing that the mortgage structure is a bad deal for most people. It allows them to buy a house without having to save up much money, which most people can't do anyway. What I'm saying, is that in no way is it a bad deal for the bank.

The inflation advantage to owning a house is that the mortgage is fixed on a standard 30 year deal, unlike renting, where the rent goes up every year. So as your salary increases, the burden of the mortgage goes down slowly, until at the end you could probably pay off the remainder in advance and rid yourself of the debt.

I agree that owning a house (or any other hard assets) is a great way to hedge against inflation. But you are just keeping up at that point, the actual appreciation is just not a decrease of your net worth due to inflation.

The amount I pay for everything, mortgage, taxes, and insurance, is less than what I would be paying today if I were renting my old house, even without throwing in the advantage that US homebuyers have of the mortgage interest deduction. This is because the mortgage has stayed the same while of course inflation has continued on.
Also, if real estate prices are advancing, and you put down only 20%, or even just 10% of the price, then of course leverage works with you and all your house price has to do is go up by the percentage of the amount that you put in as your down payment for you to double your money. If the house price doubles, you have a return of either five or 10 times the amount you actually put in, net the interest and the transaction cost of selling, of course.

Buying vs renting has long been debated and imho it's a very complicated topic, with probably no clear answer.

Flipping can definately make use of the leverage that mortgages offer, but for this discussion I was keeping it to mortgages that are carried to term.

For most people - at least those who would have bought before the recent bubble - this is a great deal, since generally the pattern is you buy while you're working, pay it off, sell it to go retire someplace else, and you're able to use the profit to buy the retirement house while banking the initial equity. As my parents, who rented their entire lives, ruefully observed, everyone they knew who was well off in retirement had bought the houses they had lived in during their working lives, and bought their retirement home on the profit from the sale of it.
My own house, which I bought in 1999, has doubled, if you believe the most recent appraisal. I figure I'm doing well if I can just get 50% more than what I paid, which even today is doable. I can pay the transaction costs from the paid-in equity, and keep the profit, if I so choose.

Throughout history there have been times when it was great to buy, and times when it was great to rent. In the US, it's been usually better to buy, imho, but that isn't always the case.

TNG

 

[Haroki]

Quote from Smart Money:

I always thought of it as a pass-through. You are paying 6% on the outstanding principal. The bank takes that money, and then turns around and pays another entity 4% on that money, so they get to keep the difference of 2%. But that "other entity" that loans them the money creates it out of thin air.

Am I wrong?

SM

Honestly, Iim not sure what you're trying to ask. Sorry. So take this answer for what it's worth.

It sounds like you're right as far as the pass through, if you mean that they're paying the central bank 4%?

Where I would continue to disagree with others is that the money to be loaned is created out of thin air. Banks do the pyramid or ponzi scheme, granted. Or rather it just looks like it. They take assets/promises to repay loans and loan again against that. It may be a little emotionally alarming when you think about that, but really, what is the difference between loaning out money against deposits or assets? I don't see a difference.

But this part below is why I think it's fine to do that.....

But the main point that I'm trying to get to, which I believe trefoil answered above, is - does the bank indeed make zero interest on their money after 2 yrs of 3% inlation due to the devaluation of the dollar they now receive....