Can Someone Explain "MONEY ILLUSION" In Layman's terms


S

sam1967

My economics is so-so. Been reading up on house prices again and the
phenonemon called "Money illusion" whereby people think buying a house
is cheaper when interest rates are lower but in fact they will end up
paying exactly the same because of low inflation.
Anyone care to comment ?
 
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A

AndyA

My economics is so-so. Been reading up on house prices again and the
phenonemon called "Money illusion" whereby people think buying a house
is cheaper when interest rates are lower but in fact they will end up
paying exactly the same because of low inflation.
Anyone care to comment ?
I think it means that although with lower interest rates the amount of the
repayments will be lower, with higher interest rates and inflation you will
be paying back higher amounts but the 'real' value of these repayments
and the outstanding mortgage will be reduced over time by inflation.
 
S

Steve Glynn

My economics is so-so. Been reading up on house prices again and the
phenonemon called "Money illusion" whereby people think buying a house
is cheaper when interest rates are lower but in fact they will end up
paying exactly the same because of low inflation.
Anyone care to comment ?
I'll give it a shot.

Assuming that people are borrowing money to buy a house, obviously it's
cheaper to borrow the money at a lower rate of interest than at a higher
rate. If I lend you £100, obviously you'd rather pay it back to me at 10%
interest rather than 20% interest a year on a reducing balance, would you
not? (If you'd rather repay it at 20% and are in need of £100, please let
me know immediately, since I think we might be able to do business).

You are, I think, confusing several different things. If I decide to buy
a house for £250,000 or whatever, that's what I'm paying for it. Since
I'll doubtless have to take out a mortgage over 20 or 30-odd years to pay
for it, I'll have to factor the interest payments on the loan into my
calculations about whether or not I can afford to buy the place. The
interest I'll have to pay will almost certainly be variable over the term of
the mortgage, so it's anyone's guess how much I'll pay in total (if I could
second-guess interest rates, I'd be long since retired).

The rate of interest will, certainly, depend on the rate of inflation, along
with several other factors. And you're doubtless quite correct in assuming
that the lower the rate of interest charged on mortgages the more the seller
of the property will be able to charge for it, since, having taken my income
into account and done a few sums, the Halifax Bank are going to be willing
to lend me rather more at 5% interest than at 10% interest. Simple
arithmetic.

That's got nothing whatsover to do with how much I'll actually end up paying
in interest (rather than captial, which is obviously fixed at the time the
seller and I complete the sale) over the term of the mortgage. Nor does
it have anything to do with what the property will be worth in 5 year's
time, let alone what it'll be worth when the mortgage is repaid in full.

HTH

Steve
 
A

abelard

My economics is so-so. Been reading up on house prices again and the
phenonemon called "Money illusion" whereby people think buying a house
is cheaper when interest rates are lower but in fact they will end up
paying exactly the same because of low inflation.
Anyone care to comment ?
it is widespread....it is based on innumeracy....
eg....if you are in a market with 10% inflation....
and your boss raises your wages at the end of the year from
£100 a week to £105 many people think they are better off...
of course they are not....their real wages have gone down....
just the number has increased (from 100 to 105)

re the house....most people buy houses on the interest payment
(often plus a tiny repayment bit at first...or many another dodgy
arrangement)....
they will therefore buy a house for a capital price more than they
would have been prepared to pay if the interest payments (much
a function of inflation) had been higher....
they are not then looking at the current real capital cost....
they have again been confused by a money illusion....

it is widespread...it is not just one type of transaction....
as stated it is based on innumeracy and poor costing of projects

regards...

--
web site at www.abelard.org - news and comment service, logic,
politics, ethics, education, etc >600,000 document calls yearly
--------------------------------------------------------------------------------
all that is necessary for [] walk quietly and carry
the triumph of evil is that [] a big stick.
good people do nothing [] trust actions not words
only when it's funny -- roger rabbit
--------------------------------------------------------------------------------
 
A

abelard

My economics is so-so. Been reading up on house prices again and the
phenonemon called "Money illusion" whereby people think buying a house
is cheaper when interest rates are lower but in fact they will end up
paying exactly the same because of low inflation.
Anyone care to comment ?
as you were on about houses...i thought another example may
help....
you'll find that people buying a car or fridge will be most chuffed
to get a hundred or even £10 off...
and then not bother to bargain a house down by several thousands
or insist on a price several thousand higher....

they are not looking at the real numbers....but at propotions....
the sheer size of the numbers confuse them when they are
mostly used to small transactions.....

regards...

--
web site at www.abelard.org - news and comment service, logic,
politics, ethics, education, etc >600,000 document calls yearly
--------------------------------------------------------------------------------
all that is necessary for [] walk quietly and carry
the triumph of evil is that [] a big stick.
good people do nothing [] trust actions not words
only when it's funny -- roger rabbit
--------------------------------------------------------------------------------
 
S

sam1967

as you were on about houses...i thought another example may
help....
you'll find that people buying a car or fridge will be most chuffed
to get a hundred or even £10 off...
and then not bother to bargain a house down by several thousands
or insist on a price several thousand higher....

they are not looking at the real numbers....but at propotions....
the sheer size of the numbers confuse them when they are
mostly used to small transactions.....
what proportions do you have in mind ?
 
S

sam1967

what proportions do you have in mind ?
OK. Ive been looking some more and it seems there is a kind of
Parkinson's law taking place , namely

"House prices will rise to the point that mortgage re-payments will
consume as much of a first-time buyers income as possible"

It seems that many newbies are paying 85 % of their disposable income
servicing their mortgage. If interest rates rise this would climb
above 100 % and they'd be stuffed. House prices would then fall so
that new first-time buyers would find they were still paying 85 % or
thereabouts of their disposable income to service the mortgage.
Those poor bastards trying to service a payment greater than their
salary will have to sell up forcing prices even lower.
 
F

Frank X

My economics is so-so. Been reading up on house prices again and the
phenonemon called "Money illusion" whereby people think buying a house
is cheaper when interest rates are lower but in fact they will end up
paying exactly the same because of low inflation.
Anyone care to comment ?
The trick is to understand the effect of inflation ( discount rates)

If you have 10% inflation a payment in 1 year of a £100 is only really worth
£90.91 in todays terms.
Or in terms of how many loafs of bread etc it will buy.

In finance when people look at long term loans it is important to compare
like with like so it is normal to remove (discount) inflation and work out
the Present Value of all the future repayments, normally called PV. This PV
value is what the money will really be worth in terms of purchasing power or
how much you earn.

Now back to mortgages. Mortgages are calculated so that the repayments are
equal throughout the entire period of the loan. (assuming constant interest
rates)

However when you look at the PV's of the repayments you will see with no
inflation they are the same through out the mortgage. But with high
inflation the initial repayments are bigger but the PV's of later repayments
become smaller and smaller as time passes.

If you want to really understand you should calculate the PV's of mortgages
with high and low interest rates in a spread sheet.












With no inflation payments will be equal, in purchasing power as well as in
real terms, over the period of the loan.

In high inflation the initial payments are much higher in terms of
purchasing power while the payments toward the end of the loan are worth
much less (in purchasing power) because their worth has been depreciated by
the inflation.

It is possible to construct loans in a high interest world where payments
are equal in purchasing power terms over the period of the loan, but the
amount owing actually increases in real terms over the initial period of the
loan (even though it will be decreasing in terms of purchasing power)

Its hard to expalin :eek:(

The trick to looking at this kind of thing is to remove the inflation
interest and express all cash flows in terms of how much they are worth
today, this is called their present value.
 
F

Frank X

My economics is so-so. Been reading up on house prices again and the
phenonemon called "Money illusion" whereby people think buying a house
is cheaper when interest rates are lower but in fact they will end up
paying exactly the same because of low inflation.
Anyone care to comment ?
The trick is to understand the effect of inflation ( discount rates)

If you have 10% inflation a payment in 1 year of a £100 is only really worth
£90.91 in todays terms.
Or in terms of how many loafs of bread etc it will buy.

In finance when people look at long term loans it is important to compare
like with like so it is normal to remove (discount) inflation and work out
the Present Value of all the future repayments, normally called PV. This PV
value is what the money will really be worth in terms of purchasing power or
how much you earn.

Now back to mortgages. Mortgages are calculated so that the repayments are
equal throughout the entire period of the loan. (assuming constant interest
rates)

However when you look at the PV's of the repayments you will see with no
inflation they are the same through out the mortgage. But with high
inflation the initial repayments are bigger but the PV's of later repayments
become smaller and smaller as time passes.

If you want to really understand you should calculate the PV's of mortgages
with high and low interest rates in a spread sheet.
 
M

Matthew Robb

My economics is so-so. Been reading up on house prices again and the
phenonemon called "Money illusion" whereby people think buying a house
is cheaper when interest rates are lower but in fact they will end up
paying exactly the same because of low inflation.
Anyone care to comment ?
Sure. The critical thing is to understand the 'real' interest rate.
This interest rate is the nominal interest rate (the number quoted in
the press, the rate you *pay*) minus the rate of inflation

This is important because inflation lowers the value of money, (and
therefore lowers the value of the debt you owe)

In the past, high interest rates and high inflation meant high
interest payments early in the lifetime of a mortgage, and lower
(real) interest payments later on as inflation eroded the debt

Abelard has a lot of this stuff explained on his site at

http://www.abelard.org/inflation.htm

mainly talking about it in relation to government and inflation


cheers

matt
 
M

Matthew Robb

OK. Ive been looking some more and it seems there is a kind of
Parkinson's law taking place , namely

"House prices will rise to the point that mortgage re-payments will
consume as much of a first-time buyers income as possible"
This is largely true. This is because houses are positional goods, and
not 'normal' economic goods

This underpins the only decent (economic) arguments I can find for
worrying about income equality, and is desperately under-used by
pinkos of all stripes when arguing about 'equality'
It seems that many newbies are paying 85 % of their disposable income
servicing their mortgage. If interest rates rise this would climb
above 100 % and they'd be stuffed. House prices would then fall so
that new first-time buyers would find they were still paying 85 % or
thereabouts of their disposable income to service the mortgage.
Those poor bastards trying to service a payment greater than their
salary will have to sell up forcing prices even lower.
All true. Anyone paying 85% of their money to service a mortgage *now*
is a fool, damned fool and poor statistician

cheers

matt
 
J

JNugent

It seems that many newbies are paying 85 % of their disposable income
servicing their mortgage.
Only to the extent that "many" equals "hardly any".

In order to have (lawfully) obtained a mortgage which takes 85% of income to
service it, one's income would need to have dropped (very) sharply since the
loan was made.
 
S

sam1967

Only to the extent that "many" equals "hardly any".

In order to have (lawfully) obtained a mortgage which takes 85% of income to
service it, one's income would need to have dropped (very) sharply since the
loan was made.
the figure came from the economist. I think i may have misread it.
the 85 % refers to the size of deposit required compared to yearly
income for first-time buyers.
however the house price to average income ratio is 30 % higher than
its historic average and show signs of a bubble.
I would be interested to know just what the average percentage of
income currently being paid by first-time buyers is.
anecdotally i know it is pretty high (probably not 85 % ) but very
high.
I will check the economist again.
 
R

Roy Hutchins

My economics is so-so. Been reading up on house prices again and the
phenonemon called "Money illusion" whereby people think buying a house
is cheaper when interest rates are lower but in fact they will end up
paying exactly the same because of low inflation.
Anyone care to comment ?
In my experience -:

Buying a house with a mortgage means that you owe the Bank or Building Society
the sum borrowed plus interest.

Whether you have a 'Repayment Mortgage' (paying off some part of the capital
plus interest each month) or an 'Endowment Mortgage' (paying interest only each
month, and paying-off the capital at the end of the loan's term via an Endowment
Policy), or some other loan arrangement, you wind-up making a payment out of
your disposable income every month for the term of the loan.

Initially the repayments are likely to be a considerable percentage of your
disposable income.

High inflation brings with it a high interest rate, and unless you have a fixed-
rate mortgage, an increase in the 'Interest' part of your mortgage repayments.

But high inflation reduces the value of the unit of currency and also causes
salary increases which go someway toward off-setting the reduction in the value
of the unit of currency - you get more Pounds per month in your pay-packet,
though your new number of Pounds per month won't buy any more than did the
previous lesser number of Pounds.

So, you still owe the same number of Pounds-worth of the capital borrowed (or
outstanding), but you owe more Pounds in interest.

If the rate of inflation then reduces, the rate at which your salary is
increased to cover inflation also reduces - but so does your interest
repayments, but the fact that you now get more Pounds per month makes the
capital borrowed (or outstanding) less of a multiple of your annual salary.

If you earn 5,000 and borrow 15,000 - frightening - and the repayments are a
struggle.
High inflation and high interest rate - repayments becoming a little less of a
struggle.
After some years the inflation and interest rate falls - but past inflation
means that your 5000 pay is now 20,000 - but the capital borrowed is still only
15,000
20,000 now, buys no more than 5,000 did then - but 15,000 back then was three
times your annual salary, now it is three quarters!
 
M

Matthew Robb

the figure came from the economist. I think i may have misread it.
the 85 % refers to the size of deposit required compared to yearly
income for first-time buyers.
Which is very different...
however the house price to average income ratio is 30 % higher than
its historic average and show signs of a bubble.
I would be interested to know just what the average percentage of
income currently being paid by first-time buyers is.
anecdotally i know it is pretty high (probably not 85 % ) but very
high.
I will check the economist again.
cheers

matt
 
S

sam1967

Which is very different...
yes but first-time buyers are still paying an historically high level
of their income to service their mortgage. according to the Economist
it is 30 % higher than historical averages and is very bubbly.

anyway the question is when will it bust and by how much percentage
wise ?
 
C

Chris Game

(e-mail address removed) said:
yes but first-time buyers are still paying an historically high
level of their income to service their mortgage. according to the
Economist it is 30 % higher than historical averages and is very
bubbly.

anyway the question is when will it bust and by how much
percentage wise ?
This topic seems to be popular in the Economist recently - one of the
articles discussed this point at length and was quoted on another
thread (Brick Wall) on here. All this sound like the stuff the Daily
Reckoning pump out, er, daily. Has the Economist taken on some free
marketeers to the editorial staff recently?
 
S

sam1967

(e-mail address removed) said:


This topic seems to be popular in the Economist recently - one of the
articles discussed this point at length and was quoted on another
thread (Brick Wall) on here. All this sound like the stuff the Daily
Reckoning pump out, er, daily. Has the Economist taken on some free
marketeers to the editorial staff recently?
it is only stating the bleeding obvious. trying to stop more idiots
from cashing in on the completely imaginary value of their house and
hence saddling themselves with debt they cant pay.
Galbraith has written all that needs to be written about bubbles in
stock markets and real estates. His book "A Short History of Financial
Euphoria" although only 90 pages or so tells you everything you need
to know about how this bubble will end exactly like all the others.
"Irrational Exuberance" was quite good also but not as good as
Galbraith.
 
T

Tim

yes but first-time buyers are still paying an historically high level
of their income to service their mortgage. according to the Economist
it is 30 % higher than historical averages and is very bubbly.
Does this mean that they are taking mortgages out which are around 2.6 times
"historical average"??

Or are you thinking about the statistic that "average house price divided by
average earnings" is now 1.3 times a long-term average? Which again, is
very different.

anyway the question is when will it bust and by how much percentage
wise ?
I think you've missed a question! - "Will it bust at all?". If the answer
to that is "yes", then you can ask the above question....
 
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S

sam1967

Does this mean that they are taking mortgages out which are around 2.6 times
"historical average"??

Or are you thinking about the statistic that "average house price divided by
average earnings" is now 1.3 times a long-term average? Which again, is
very different.
The Economist articles Ive found are a little bit reticent with the
actual figures. ill track down some better figures and post them here.

I am 100 % certain there will be a house price crash.
Just as I was 100 % in August 2002 there would be an imminent war with
Iraq.
 

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