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Help me give good advice: Adjustable or fixed rate loan?

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Marko Posted: Tue, Feb 14 2012 5:15 PM

If you were forced at gunpoint to take out a loan now what kind it would be?

Help me out here. I know it is a bad time to be taking out loans, I advised against it, but advice was not taken. So I want to at least give good advice on what type of loan to take. With an adjustable or fixed rate?

Normally I would not be in doubt at all, I would say go for a fixed rate. However, normally you could get a loan on decent terms, so by going in for a fixed rate you would be locking in a decent interest rate. But with loans so expensive now and the banks particularly hostile to fixed rate loans, going for one sounds a lot like paying extra to lock in a high interest rate.

Here are terms that are avaliable:
1. Fixed rate:
Loan size: 45,000€
Monthly payment: 400€
Time it would take to pay off: 14 years, 4 months
Combined money paid back: 69,150€
Interest rate: 6.67%

2.) Adjustable rate (6M Euribor + 2.7%):
Loan size: 45,000€
Monthly payment: 400€
Time it would take to pay off: 11 years, 11 months
Combined money paid back: 57.503€
Interest rate (at start): 4.30%

Which one would you chose?


Here is Euribor chart for past years if it helps any:





At around 1.6% at the moment it is close to its historic low actually.


So on the face of it it would seem EURIBOR would need to hit 4% for the fixed rate to be better than adjustable rate, but it has rarely been that high.
On the other hand, why are the banks so averse to offering a fixed rate loan (a few do not even offer this option), do they know something I don't?
Finally what happens to the central bank's interest rate if there is really bad inflation, how high can this thing go if SHTF or thereabouts?


This is pretty important so I encourage you to say anything that may come to your mind regarding this.

)
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Marko:
I know it is a bad time to be taking out loans

Why?

 

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Marko replied on Tue, Feb 14 2012 5:29 PM
Because you don't want to be in debt in general, but particularly when there are bad economic times and on the way to becoming still worse. Does that make sense?
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Wheylous replied on Tue, Feb 14 2012 5:39 PM

The general advice of people on this forum appears to be to not rush to pay off debts, as inflation in the future will make it easier to pay the debts.

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Marko:
Does that make sense?

No, not really.

 

you don't want to be in debt in general

Only people who don't understand investing agree with that.  I mean, I guess one could argue in a technical, general sense that it would be preferable to not have debts as opposed to having them, but at the same time there's no way to really go into debt without taking on debt...which means if you care about getting ahead financially (in a significant way, at least), at some point you're going to have to be in debt.

The whole point is what the borrowed funding is used for.  In finance debt is called "leverage" for a reason.  Investing guru Robert Kiyosaki says "A lot of people say they lie awake at night because they're worried they have too much debt.  I lie awake because I'm worried I don't have enough debt."

What he's talking about is leveraging the resources you have to achieve maximum financial growth...a lot in the way an appropriately placed lever can maximize the amount of weight that can be lifted.

Of course he's not talking about overextending yourself, he's more just trying to wake people up to the fact that there is "good debt" and "bad debt."  For most people "debt (period)" = "bad".

If you're interested, his flagship text is Rich Dad, Poor Dad.  It's not so much of a financial advice resource, as much as a "look at things differently" aid.

 

but particularly when there are bad economic times and on the way to becoming still worse.

A large part of the bad economic times ahead are due to the coming inflation.  An inflationary environment is the best time to be in debt.

I had a somewhat related conversation with Malachi about this a while back.

 

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Marko replied on Tue, Feb 14 2012 7:09 PM

Ok but this is not a loan for investing and becoming a capitalist. It is for tearing down an old house and raising a new one in its place. 15 years does not sound like a trivial amount of time to sign your home over to the bank for.

Anyway you set my mind at ease about the wisdom of taking out a loan as such, but that still leaves the question of what kind. What happens with adjustable rates in an inflationary environment?

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Marko:
Anyway you set my mind at ease about the wisdom of taking out a loan as such, but that still leaves the question of what kind. What happens with adjustable rates in an inflationary environment?

It depends.  Obviously, initially rates are pushed down by the expansion of credit.  But eventually (one way or another) they'll go back up.  I went into this a bit here.

So it really depends on what the central bank does.  I actually didn't think about the fact that you're talking about Europe.  I'm not as familiar with the laws there, nor the specifics about the banking system and what the ECB is up to.  Although, I do know it's not far from the US situation.  But there are important differences.

If this were the US, I'd tell you fixed rate is definitely the way to go because rates essentially have nowhere to go but up.  They are at virtual all time lows.  The Fed Funds Rate has been at 0% for over 3 years.  Think about that.  0%.  Sure the mortgage rates farther down the interest ladder have fluctuated a bit, but you haven't seen rates like them in a long time, and they're not going to get any lower (generally speaking).  You lock in a 4% rate now, when real inflation is probably 9% or 10%...and just watch your debt inflate away as the value of the dollar falls precipitously in the coming years.

Again, I'm not as familiar with the European situation, but I'd wager the advice would be the same, for essentially the same reasons.

If you're really interested, I'd call in to Peter Schiff's radio show and ask him personally.  He'd be able to tell you for sure.

 

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Let me make sure I understand. You are considering the option of letting the bank, for 15 years in a row, decide how much interest they will charge you, with no limitationon them. If you don't pay every month to the last dime, you lose your house.

Maybe this might make sense, entering a gambling situation like that where you are powerless and at their mercy, if two conditions are met. First, that the down payment you made is a trivial amunt, so that the worst case is you lose that trivial amount when they take your house away. Second, that the initial monthly payments, until the time comes for the banks to decide how much to charge you for the future, is more or less the amount you would pay to rent such a house.

If those two conditions are met, then basically you are renting the house for now, and when they reset the amount, you can walk away and hand them over the keys if it is too much for your liking [after perhaps first stripping the house of every possible item of value, the fixtures, the pipes, everything. After all, it's legally your house till they kick you out, right?] 

Bottom line, if it pays to consider this whole thing just a way of renting the house until they want too much rent, then I guess there is something to talk about. But if you stand to lose a bundle when they take away your house, and so you are relying on them being reasonable when the time comes to up the interest rate,  I dunno. You hear stories about prostitues with hearts of gold, but never about bankers. 

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John James replied on Tue, Feb 14 2012 10:29 PM

Smiling Dave:
I dunno. You hear stories about prostitues with hearts of gold, but never about bankers.

What about badass mail clerks and logical forum posters?

 

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Chyd3nius replied on Wed, Feb 15 2012 12:14 AM

When inflation hits, interest rates rise. If you expect inflation, then fixed rate is a good one. And about inflation, it depends do you live on EU or in USA.

-- --- English I not so well sorry I will. I'm not native speaker.
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Clayton replied on Wed, Feb 15 2012 2:17 AM

Fixed rate unless you are in the business of interest-rate speculation. If you can't afford the fixed rate, then you can't afford the loan. Don't take it out.

</thread>

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http://voluntaryistreader.wordpress.com
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Marko replied on Wed, Feb 15 2012 5:03 AM

Thanks all. I'm going to advise a fixed rate. I hate that the terms are as they are when they used to be considerably better, but that just means the banks themselves are now aware inflation is coming, and since I knew that before they did, what do I have to be uneasy about. It may take longer to pay off but in 15 years time 400€ won't be as nearly as hard to lay hands on as it is now, so it is not *that much* of a factor.


Of course, what you did now is to make me a debt enthusiast and half set my mind on getting a cash loan for myself to buy physical gold, or some gold index with it. I'm going to have to sleep on this, lest I do something stupid, but it seems intriguing.

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Adam_Just replied on Wed, Feb 15 2012 5:26 AM

Loans with a fixt rate will be more expensive everywhere, because all the economies in the world (except for Asian countries perhaps) are in bad economic conditions and projections. So the banks cover their future potential risks making fixed rates higher and loans more expensive. That's rather normal, because I think the economic situation in many countries doesn't have very positive scenarios of development. 

But the decision also depends on other factors, maybe subjective ones..

 

No man is good enough to govern another man without that others consent! - that's wise idea which I used in my Note accessories blog ..
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Chyd3nius replied on Wed, Feb 15 2012 5:26 AM

If inflation hits(I think it's going to hit both in EU and USA at some level in few years) then the real value of your debt will get lower. Fixed interest rate loan is best one in inflation, because inflation rises interest rates and you are safe from that, but rising prices and wages will make your real debt smaller.

-- --- English I not so well sorry I will. I'm not native speaker.
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TANSTAAFL replied on Wed, Feb 15 2012 9:29 AM

Advise the fixed rate. I would also advise to take the loan for an amount that the monthly payment is lower than what canbe afforded. The rate can effectively be lowered and loan paid off much sooner if more than the required payment is made each month.

 

The variable rate seems nice because it lowers the monthly payment. The risk is that the rate rises and your 300 payment becomes 1,000. It is more likely than not that at some point in the next 10 years the holder of the adjustable rate loan will face a rising rate and lncreasing payments.

 

Tha bank does not want the fixed rate loan because it expects inflation. Inflation helps the borrower at the expense of the lender. The money the bank recieves in payment has less purchasing power, is less valuable, than the money it lends out.

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Fixed or Variable?

Taking out a fixed rate loan because a borrower believes that the money paid back per unit will be worth less than the money borrowed, is essentially a prediction of future inflation, using the money borrowed as a "surefire" bet on that occurrence.  

A truly variable rate loan however [most are not- you have to check the fine print],  is  not an attempt to predict future economic events and remains neutral in economic outlook, which makes it far more  "user friendly" if   instead, systemic deflation hits, when each unit of currency that the borrower must pay back is worth more, not less, and where a fixed rate might  cause severe distress to the borrower

Since human action theory reveals that  no one [not even the banks] can reliably, consistently predict future economic events, [therefore further future deflation is still a distinct possibility]  the question  for your borrower  appears to be : "Do ya feel lucky, punk?" 

Regards, onebornfree.

For more information about onebornfree, please see profile.[ i.e. click on forum name "onebornfree"].

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Minarchist replied on Wed, Feb 15 2012 10:49 AM

If I had to borrow, I would borrow at a fixed rate. Rates can't drop much more, so I wouldn't worry too much about missing an opportunity for a lower future rate, and though I doubt they'll rise meaningfully (because States will keep suppressing them), why take the chance? An adjustable rate loan right now strikes me as all-risk and no-reward.

Keep in mind also, if you plan for inflation to "pay down" your loans, you have to either own an asset that will keep up with inflation, or have an income that will keep up with inflation. If you have no job and no hard assets, inflation is the worst environment in which to be a debtor: i.e. your income stays the same and your living expenses rise.

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Since human action theory reveals that  no one [not even the banks] can reliably, consistently predict future economic events,

Who told you that? In other words, a source please.

  no one [not even the banks] can reliably, consistently predict future economic events,

All we have to do here is predict one economic event, one time. That there will be inflation. No need for reliably and consistently predicting events [=plural].

human action theory reveals that  no one [not even the banks] can reliably, consistently predict future economic events,

What I don't get is, if we assume you are correct here, then why bother studying economics at all? If the bottom line is "you can't predict anything" doesn't that mean "close the books and turn on the basketball games"?

Here is my take: Human action theory teaches that...

1. ...there is a cause and effect relationship between economic events. There is a Law of Supply and Demand. There is a Theory of the Business Cycle. There is a Law of Diminishing Returns. And so forth. And although all the laws assume ceteris parebis [=all other things remaining unchanged], and in the real world everything changes, yet ...

2...some causes are way more powerful than others. As an extreme example, Obama deciding to invade Iran influences the economy more than me buying a dozen eggs.

Of course, Economics per se limits itself to if-then statements. If the Fed prints more money, then all other things being equal, prices will go up. An economist, while wearing his economist hat, will not consider it his job to predict whether the Fed will indeed print more money or not. All he discusses is the consequences of what happens if they do or they don't.

Thus a whole new field of knowledge is introduced when trying to predict economic events, what we may call psychology. What kind of people run the Fed? What have they done in the past, what are the likely reasons they acted the way they did, and is there reason to think they will act that way in the future? Obviously, this whole area is more an art than a science, though the theory of human action gives us a bit of a hint. They will probably do what they percieve as best for them.

All of the above leads me to conclude that...

3... though nobody is likely to be perfect, some people will be far better at predicting future economic events than others

Summing up. The uncertainty we all have is in predicting what people will do. And there is uncertainty as to how much influence their action will have on the future. But...

4... there is no uncertainty about the direction of the influence of past actions on the future. 

For example. We do not know for sure if the Fed will print money tomorrow [though shrewd people can make excellent guesses]. We do not even know for sure if the money printing that causes prices to rise, ceteris parebis, will be offset by other factors, leaving prices the same or even lower. But we do know for sure that yesterday's money printing by the Fed will introduce a force which will push in the direction of higher prices. We also know that the more money printed, the stronger this force will be.  

Now let's look at what is before our very eyes. Fifty years ago, politicians and economists all agreed that inflation was bad. It was even considered a given that printing money caused inflation [See Keynes remark about debauching the currency]. Nowadays, things have changed. Every single politician with power anywhere in the world, and every single economist with access to the media or with any other power, lets it be known that inflation is a good thing, and that besides, printing money doesn't cause prices to rise, and that besides, the central banks do not really print money, and that besides we never did have inflation, really, ever. In other words, they are announcing for all the world to see that they intend to print money till prices go up. And they have done it in the past. 

One doesn't have to be an Albert Einstein to make the following argument. They have printed money in the past. The have the power to print more, and announced their intention to do so, telling everyone how wonderful it is. Ergo,

5...the probability of their printing more, so much that prices will keep on rising like they announced is their intention, is enormous. Protect yourself.

 

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SD: "Who told you that? In other words, a source please." 

 

" When the businessmen finally learned that the boom created by credit expansion cannot last and must necessarily lead to a slump, they realized that it was important for them to know in time the date of the break. They turned to economists for advice.

"The economist knows that such a boom must result in a depression. But he does not and cannot know when the crisis will appear. This depends on the special conditions of each case. Many political events can influence the outcome. There are no rules according to which the duration of the boom or of the following depression can be computed. And even if such rules were available, they would be of no use to businessmen. ....." 

 

Taken from: "Human  Action":   XXXVIII. THE PLACE OF ECONOMICS IN LEARNING -3. Forecasting as a Profession 

 

See also : "The Folly of Forecasting" by LVM's own Doug French 

 

Regards, onebornfree. 

P.S. I'm not looking for an argument SD. If you believe that you _can_ accurately predict future economic events, then have at it, and more power to you! 

For more information about onebornfree, please see profile.[ i.e. click on forum name "onebornfree"].

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TY, onebornfree, for posting your souces.

OK, we need not argue. I leave it to the reader to see that both sources say the oposite of what you claim they do.

Regards,

Dave

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gotlucky replied on Wed, Feb 15 2012 2:59 PM

@Smiling Dave

I just wanted to say that your post laying out your argument is excellent.  I like the style and format (the information and argument are good too :p).

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ty gotlucky

have a look at my blog

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