Interest rates explained

I often get into conversations about how it's a great time to buy homes because of the historic low interest rates.  It's an excellent time to buy under the right conditions though.  Unfortunately, many of my friends don't know what they are because they don't understand the role interest rates play in the economy.  I bought a home recently but I put no money down and view the house as a place to live rather than as an investment.  But before we get any further into the discussion, let's first establish our definitions.

First of all, we'll divide the acquisition of assets or durable goods in the market based on the purpose of their usage.  In other words, are we buying something for consumption or production?  To explain the difference, imagine walking through Costco and looking at all the people shopping.  Most of the people are buying things to take home and use.  Then every once in a while you see that guy who has 20 cartons of milk, stacks of water and other staples.  That guy is buying the stuff at Costco for productive purposes.  The rest of us are buying for consumption.  The productive purpose is to take the low prices at Costco and reselling it in an area where the prices are high enough to generate a spread wide enough to warrant the work necessary.  Consumption is any act that satisfies the needs of the person consuming the product.  So a house can be 'consumed' in the sense that it provides shelter because shelter is the desired use from a house just like a Snickers bar satisfies the desire that is created from hunger.  Production, on the other hand, is any act that creates value in the market.  So that guy at Costco buying 20 gallons of milk is creating value because there is demand for milk that isn't being satisfied.  Just like a house can be productive asset if value is created (e.g. generates a positive return on investment or ROI).

Now that we've differentiated production from consumption, we need to understand the difference between an investment and speculation in any given asset class.  Most people speculate.  They speculate in stocks, bonds, precious metals, real-estate, etc.   Very few are investors.  Here's the difference.  Speculators hold a position in an asset class, either by going long or by going short (I'll describe this in a minute), with the belief that the asset price goes up or down, resulting in a profit.  The term 'going long' is what most people understand as 'buy and hold.'  When people 'go long' they hope for price appreciation.  'Going short' is the opposite of going long.  Going short is when you borrow an asset and then selling it.  The way you make money in this fashion is to hope the price of the shorted asset goes down in price and you buy the asset back at the lower price and return the asset back from who you borrowed it from.  So if you shorted Apple stock (APPL), you would borrow, say 100 shares,  and then sell at $200 a share.  So you immediately get $200,000.  But you also owe 100 shares of APPL.  Then if and when the share price drops to $150 you buy it back.  That cost you $150,000.  So you subtract the $150,000 from your initial $200,000 and you just netted $50,000 and now return the 100 shares of APPL back.  It should be obvious that when shorting, you want the price to go down, not up.  In either case, the only way to make money is to exit out of your position in a way that generated a profit.

Investing is different in that you are chasing a yield or a ROI.  Many will argue that there isn't a big difference between speculation and investing because you can calculate ROI from buying and selling.  True, but what they forget is you can only calculate ROI after you have exited your position.  Investments generate income simply by holding onto an asset.  You can't do that by flipping stocks.  You only get paid at the end of the transaction, not during.  So real-estate investors buy and hold real-estate and hope to get paid rent.  The idea is (Rent - Mortgage - Property Taxes - Maintenance fees - other costs to owning a rental property > 0).  In fact, to calculate your annual ROI, you would take the result of that equation, multiply it by 12 (because rents are monthly) and then divide it by the down payment for the house.  The down payment is your initial investment.  The rent is not only your return but your income for holding on to the property.  In other words, you are getting paid, or rewarded, for holding onto this asset.

Now that we've thoroughly defined consumption, production, speculation and investing, we can finally move on to the meat of this blog....interest rates.

We need to first understand what interest rates really are.  In order to do that, we need to start by understanding money.  So money is, as I have defined before, a commodity that allows indirect exchange (direct exchange being bartering).  Since exchanges come in all different forms, the commodity needs to be flexible enough to handle them all and so commodities that are transportable, divisible and durable were the ones most demanded.

A good way to think about money is each person is like a gear in an engine where each gear wants to interact with other gears and money is like the oil or lubricant to make the whole thing run smoothly.  Once we understand the role of money, in this sense, we can focus on an important truth.  And that is, you cannot spend money and save it at the same time.  You are either in an exchange or you are not.  Austrian economics talks about 'time preference', which is the general preference in society to either save or to spend.  A high time-preference refers to a preference of present-day consumption over future consumption.  A low-time preference refers to a preference of future consumption over present-day consumption.

These time-preferences have huge implications.  In order to consume today, you must spend money in the present to purchase goods and services for consumption purposes.  What that also means is that money being spent cannot be saved.  It also means when people prefer to defer consumption to a later date in the future, more money is being saved in the economy.

So now we come to the point where we can imagine a pool of savings in a society that can expand and shrink based on society's general attitude about the future.  On one extreme, if we new an asteroid would hit the planet and destroy the earth, there would be virtually no savings.  We would have extremely high time-preference.  Another way to look at it is on an individual level.  If someone told you that you would die tomorrow you'd probably go out with a bang.

Back to the pool of savings in an economy.  We can now measure the supply of savings at any given time and as we can now add a new element to this: demand.  Once an economy gets off its feet, it is savings that allow people to engage in new activities.  To show this, imagine where you lived hand-to-mouth and picked and ate only berries.  Your only activity is really searching for and eating berries.  Now if you were able to save excess berries, you could either enjoy leisure from picking berries or try your hand at hunting game while you existed on your savings.  The point is, you are freed up from picking berries to "invest" in other activities.  In a more complex economy though, the general savings allows some people to borrow it in order to engage in new economic activity such as starting a new business.  And so the demand for savings is the willingness for others to borrow it.  Some people may borrow for the purposes of consumption and others borrow for productive purposes.

Thus the supply and demand for savings creates a price for savings, e.g. interest rates.  However, there isn't just one main interest rate.  There are different amortization periods.  You would charge someone who wanted to borrow $100 for a day a different rate than someone who planned on paying you back in a year.  The longer the term, the higher the interest rate because you forego spending the money for a longer period of time and there is less certainty you'll even be around in a year compared to tomorrow.  This is where the 'yield curve' gets is shape from.

Problems arise in the economy when interest rates are manipulated by a central bank.  Remember that interest rates reflect society's attitude regarding spending today versus spending tomorrow.  By lowering the interest rate artificially, it's sending an artificial signal that the supply of savings is high and/or demand for savings is low.  Thus the low interest rates attracts people to borrow but since it is artificial, there isn't enough real savings so the central bank must print the difference.  But this isn't how it really works.  Interest rates are artificially pushed down by printing money thus spreading the value of the existing savings over a larger number of monetary units.  Then the borrowing begins.  The problem is the investments from the borrowing cannot all yield positively because the people preferred to spend in the past, which was the present when the interest rate was artificially lowered, over today.  They collectively lack enough purchasing power in their money to keep the new investments afloat.

It's the printing of money to purchase government bonds that drive interest rates down.  Government bonds are just IOUs they use to borrow money.  As that might spur people to borrow in the private sector, it also stimulates government spending in the short term.  The IOU must be paid back so ultimately that falls on the shoulders of the taxpayer to do so.  Not only does it create an atmosphere to get people to borrow money, it also precipitates an ensuing bust in the economy.  Let's not forget the obvious - that printing of more money is inflation.

Inflation is a lot like opening up a brand new bottle of OJ, opening it up, take a glass and then filling it back up full with water.  Each subsequent glass becomes less real OJ and more water.  Repeat the process enough times, all you'll end up is funny tasting water.  The rate of inflation refers to how fast money is being depreciated simply by holding onto it.  Since we live in a world where interest rates are manipulated, we must discount the rate of inflation to get real interest rates.

For a 30-year mortgage, borrowers can get anywhere in the mid-to-high 3 percent range today.  Considering the real rate of inflation is well above that (I don't trust the CPI), many people will be benefitting from buying a home at a fixed rate, in the form of depreciated future dollars to pay their mortgage in 30 years.  Of course, the banks get screwed because they have to hold on to the paper for 30 years earning no real interest.  But they have an ace up their sleeve.  A government bailout paid for by 'you-know-who.'

But it's also not such a great deal for anyone who plans to put down the 20% a lot of banks are now requiring because of the tightening of lending standards.  Not only are they putting their present-day dollars into a depreciating asset that requires constant maintenance, they will also be losing money, as with the rest of us as taxpayers, in the form of bailing out the banks in the future for the artificially low interest rates for today.  Sure, the nominal value of their homes may increase but their purchasing power will have declined.  What good is living in a million dollar home if the average car costs $50,000 and a tank of gas costs $200?

It's much better to find something that will return something above the rate of inflation for your 20% down payment than to put it in as equity into a home.  Even though home prices, in the past year, have appreciated to almost 11%.  After discounting for inflation, you're only looking at a few percentage points of real gain.  You can try your hand in flipping homes but what happens if your timing is off and you're left holding the bag?  Will it be worth those few percentage points?

It's perfectly fine to buy a home and put your 20% down if you what you want is a place to live but don't fool yourself in thinking it's an investment.