The Real Cost Of Credit

The following is a guest post from reader BP

The Real Cost Of Credit

The real cost of credit needs to take into account earnings notably the after tax or disposable income. Interest rates are one thing - the level of indebtness is another! Current levels of debt to disposable income are about 80% - it used to be about 52% until about 3 years ago when it suddenly took off. Such easy credit fueled the property run. Property was never "cheap" in the first place - easy credit pushed it to dizzying heights. At the same time from mid-2003, we had an equity bull market. By all means the residential property market outpaced it - in cape town it did. Where would that be a normal occurence? It is an incredible exception - not to be repeated for a very long time.

As interest rates respond to inflation that is grinding down peoples spending power and hurting the poor, people are crying about high interest rates. Did they never conceive that interest rates could increase from multi-decade lows? Or was it different this time - as told by the knowledgeable estate agents! And inflation will rise further as will prime. bets are on for a definite 50 points next month and a 60% chance of another 50 points in August! Prime at 16%. Not too high?

Consider the following 2 useful indicators:

1) The cost of debt-servicing as a percentage of Income. Current debt to disposable income is 80% and interest rates are 15% (15.55 next month). that means that the real cost of servicing is the product of these 2 or 12% (12.4% next month). Not too high? Consider the crisis of 1998 - debt to disposable income was 52% and prime hit 25.5% making the cost of servicing 13.26%. sure it only stayed there for a short time but it did d damage. We are currently not too far off that now. Prime at 16.5% equates to this punitive figure (16.5% * 80% approximates 25.5% *52%). BUT even so it is not only the level that counts but how high it stays up there! In effect, looking at a graph, it is not the curve that is important but the area under it (the integration of the curve for the mathematically minded). And with inflation set to rise further bet on it staying up there longer.

2) The penalty for borrowing money is actually the real cost of a loan, simply the difference between inflation and the prime rate. Currently it is 4.4% (15% - 10.6%) which by historical standards is really low - the average over the last 15 years is about 7%. so another 1.5% - 2% increase in prime is not impossible to equate to the average.

These two indicators indicate one thing: interest rates will increase in the near term and will rise further before they can be considered as "punitive".

A last comment on inflation. With commodity prices staying high (as per the CRB index of overall commodities), inflation has to feed through. It has already started in food and fuel. Wait for cars, clothing, furniture, and so on. and even though the economy stagnates, if inflation is rising the Reserve Bank HAS to raise rates. In the past, this is what Central banks have done. Such "stagflation" (economic stagnation and inflation rising) portent very hard times. Remember the "sour 70's" where a series of crises and market reversals ruined fixed asset values. They can easily arise again. My view is that they are which is why all my money is in cash products.