What will make loans pricey

As I established in my previous post a loan is basically the present value of your future income. From the bank’s perspective they are buying an annuity, where the price is depending on interest rates, risk premia, maturity; ordinary debt market metrics.

After the recent Fed interest rate hikes some articles surfaced which predicted a new credit crisis, similar to the one we had in 2007-08. Sometimes I couldn’t decide whether the authors actually meant what they claimed, or just wanted to create a good clickbait by using people’s fear. Either way, here are two points why I find it unlikely that such collapse could happen anytime soon.

Firstly, after the last crisis there has been a serious deleveraging among the households. Secondly, household debt servicing-to-income ratio is at historical lows (however the series are only going back a couple of decades), and expected to stay low, partly because of our first point.

At this side of the yield spectrum (and will decrease as yields rise) each quarter percentage point of increase in borrowing costs increases debt servicing between 0.7 and 3.8 percent (calculated on a 5 and 30 year loan respectively). However, the other side of the equition, namely household (median) income is increasing 4 percent annualy too, meaning that the difference between the cost of maintaining your household balance sheet, your own personal enterprise, and what it yields for you (given that you are working) do not rise until the Fed hikes only once or twice a year.

Please do not be decieved by the numbers; again, this does NOT mean that all your additional income goes to debt repayments, only that your debt servicing / income ratio will stay constant with having more disposable income in nominal terms.

What will eventually do the tightening is the expected rate of hikes. As banks account for future financing costs too, more hikes will translate into higher current loan yields.

Lastly, higher yield might actually mean lower savings, giving an extra impulse for the economy. The rationality behind this is the big comeback of compunded interest. As rates got lower in the last couple of years savers were only able to get back what they put into their accounts, meaning that you had to save more to reach your future target (e.g. pension).

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