While in B.C., I had a conversation with my father-in-law about mortgages. I told him that one thing that irritates me is when I hear people say that right now is a great time to buy because interest rates are so low.  This is a shortsighted view that doesn’t take into account the fact that interest rates are artificially low.

One major element of the sub-prime interest rates debacle is that people were offered mortgages that had artificially low interest rates in order to entice them to buy. They were excited that they could finally get a mortgage and at a great rate. Unfortunately, shortly afterwards more realistic rates kicked in and homeowners realized they couldn’t afford the true payments on their houses and they defaulted.

Today’s situation is not completely the same, but there is one striking similarity. As with the sub-prime scandal, current interest rates are unrealistically low. According to Canada Mortgage and Housing Corporation (CMHC) data, May 2009’s 4.62% 5-year fixed mortgage rate is the lowest our country has seen in at least 58 years. The closest rate was 5% in March 1951. Thus, we shouldn’t look at current interest rates as a blessing because they are rare, unrealistic and unreliable. It would not be in a homeowner’s best interest to base decisions on this rate.

We need to ask ourselves, “What will happen when historically accurate interest rates return?” The median interest rate this millennium has been 6.24%, the median in the 90s was 8.67%, and in the 80s it was 12.65%. These rates represent a more accurate picture of what interest rates will be throughout the life of your mortgage. Can you afford these rates? Will you be a sub-prime victim and realize in 5 years you can’t afford your mortgage payments?

To put these interest rates into a different perspective I computed the weekly mortgage payments for these 4 interest rates. I used weekly payments because it will decrease your interest charges. I also assumed a 5-year fixed term on a 25-year mortgage. Lastly, homes sold for an average $245,000 in the Halifax CMA, so I assumed a 5% downpayment; translating into a mortgage amount of $232,750 (See Table 1) .

Would you be able to afford mortgage payment increases of $200.92 or $526.08 per month? I’d imagine that a lot of homebuyers hope that an increase in mortgage payments 5 years from now will correspond with an increase in salary. But, we would then have to factor in income taxes. And, one would have to be born yesterday to believe that a salary increase doesn’t result in an increase in consumer spending (i.e. clothes, cars, entertainment, etc.). Therefore, in order to drive my point deeper, I’ve assumed a 35% income tax rate on the salary increase and that only 50% of the pay increase goes towards the increased mortgage payment (See Table 2)

In your profession, will you be able to achieve a $7,418.58 salary increase in 5 years? $19,424,49?

I’m not into fear mongering and I don’t want this article to come across that way (the sub-prime reference was borderline, I admit that). All I want to highlight is that interest rates are artificially low, and as such should not be regarded as a blessing, but as an abnormality that should be treated with suspicion. If you can afford your dream house now, big deal. You have to crunch the numbers and figure out if you’ll be able to afford it at more historically accurate interest rates. If you can presently afford mortgage payments at an 8% interest rate then you’re in a good position. If you can’t and are hoping for a pay increase down the road, is that raise possible and will it be large enough? If it will be, then you’re in a good position. If it won’t be, then you need to reconsider your options.

With this new endeavor I’ve adopted a “non-fiction only” rule. Fiction, in my mind, is fluffy, make believe, and a waste of time. Who wants to read Charles Dickens talk about some magician’s life? Sure, David Copperfield did some pretty cool tricks, but how is that going to affect me? That’s why I prefer non-fiction. I want to read about topics that I can apply in my own life.

Whether you are a little confused (a.k.a. an avid fiction reader), an intelligent non-fiction reader, or a doer, allow me to recommend two books for your summertime readings. They’re very interesting, enjoyable and entertaining. The first books will open your eyes to fun statistical arguments that you never thought anyone could prove. The second book surrounds personal finance in which the author outlines a few guidelines that one can employ in order to exit the “rat race”.

Freakonomics: A Rogue Economist Explores the Hidden Side of Everything    The authors, Steven D. Levitt and Stephen J. Dubner, explore fascinating topics that one would not expect to be researched, let alone published.

One topic that is covered is why drugs dealers still live at home with their parents. He uses insider information to show that drug dealers don’t really make that much money, just a few select at the top do. But the reason why those drug dealers still deal is because those at the top make A LOT of money. So, they weigh the pros and cons and decide that it’s worth the chance.

Another topic researched is parenting tactics. The authors use statistical data to argue that parenting tactics don’t play a major role in the educational success of their children. It doesn’t matter whether one parent stayed at home, or both parents worked; whether a child is read to, taken to museums, or spanked. What matters most is simply the parent. If a parent is well-educated, statistically the child will become well educated as well. All in all, this is a very fun book to read and it will show you that statistics can be cool.

Rich Dad, Poor Dad There are two main points that I took from this book: the difference between an asset and a liability, and to save first and spend second. The author, Robert Kiyosaki, makes the astute observation that an asset is something that puts money into your pocket and a liability is something that takes money out of your pocket. With this in mind, a car, a boat, or a house, would be considered a liability because it only sucks out money. However, if the same belongings were rented out to generate some sort of income, they would be considered assets because they are bringing money in. The trick then is to reduce those items in our lives that suck money from our bank account, and accumulate those that bring money in.
The second point is to save first and spend second. In my experience, the average household spends the money that comes in and then saves whatever is left over. But Kiyosaki stresses that in order to get ahead financially one should set aside the savings at the beginning of the month and then spend whatever is left over. This disciplines us to be financially responsible with the resources left over and allows us to save quicker than we otherwise would have.

Now that I’ve suggested books for you to read, I’d like to hear from you. What is some   business or financial books you’d like to suggest?

Supply and demand teaches us the following: as the hourly wage increases, more employees are willing to “supply” labour. As it decreases, these employees are less willing to supply labour. These two characteristics are very intuitive, as wages increase more people are willing to work, plain and simple. (This has been illustrated in Figure 1 with the line marked “Supply”.) For employers the opposite rings true, as the minimum wage rate decreases more employers are willing to demand labour, and vise versa. This as well is intuitive, the more expensive employees become the less willing companies will be to hire more employees. This has been illustrated with the line marked “Demand”. The point at which supply intersects demand is what is called equilibrium.

The minimum wage is what is called a price floor. For a price floor to be effective it must be above equilibrium. If it were below equilibrium it would be ineffective because businesses would be willing to pay more than the minimum wage – that is, equilibrium. Consider Alberta in 2007, the minimum wage was $8 an hour but companies were paying $9 – $10 an hour because that’s what the market warranted. Businesses would not have paid $8 an hour, because, according to Figure 2, at $8 an hour only 80 employees are willing to supply labour.  However, equilibrium is 150 employees, hence companies would be understaffed.
In Nova Scotia the minimum wage is above equilibrium. We know this because that’s what the majority of fast food restaurants and clothing retailers pay their employees. Once again, if minimum wage were below equilibrium companies would be forced to pay equilibrium or risk being understaffed so they must be paying minimum wage because that is what the law requires.
Above equilibrium we have the opposite problem as we did below equilibrium. Referring to Figure 3, at the new minimum wage of $8.60 we have 220 workers willing to supply labour. But the point at which $8.60 intersects the demand curve is only 80 employees; as a result 140 people that wanted to work won’t be able to find a job. In addition, of the 150 people that were working, 70 of them may now find themselves unemployed.
Does the minimum wage really protect our most vulnerable workers? No. It creates fewer jobs for those workers who need them the most and therefore offers no protection or guarantee.

But digging deeper than that, performance bonuses are meant to reward an individual’s valiant effort from the preceding year. But, a smart bonus plan will have a company modifier attached; meaning no matter how well the executive does, if the company as a whole performs poorly, then the executive’s bonus is cut in half, in a quarter, or whatever is appropriate. I don’t know if this was the case for AIG and Nortel, and I will most probably never know. But surely a situation like, oh I don’t know, declaring bankruptcy, would cut that bonus in 3/4s. Or, as in the case of AIG, when the stock decreases from a 52-week high of $49.50 to a low of $0.33, a 99% decline, then performance bonuses should be out of the question.

Retention bonuses on the other hand are meant to retain key talent, quite obviously. Now, who are they trying to retain, the individuals that got them in the mess in the first place? You want to keep those guys around longer? Shouldn’t they be fired? An even better question: Where are they going to go?? We are in a recession here, meaning there are not many job openings available, and these executives just blew up the entire company. AIG and Nortel are their only options! I don’t think retention is an issue.

Optics aside, the logic behind these bonuses leaves me wanting. I don’t have a problem paying executives the money they’ve earned when profits are increasing and the company is growing. But when the ship’s sinking, the executives have to go down with it.