There are few ideas as bad as the conviction – common in the DFL – that government should act as nanny, preventing the kiddies from hurting themselves by running with scissors.
Two of this week’s legislative actions reflect that view.
The first is a ban on prepayment penalties in home mortgages. The second bans expiration dates or fees on retail gift cards or certificates. Both are bad ideas. Minnesotans will be worse off if they become law.
Both measures interfere with the ability of private individuals or businesses to make agreements that both parties find favorable. You don’t have to be a full-blown Libertarian to find this troubling.
Both are intended to protect consumers from exploitive practices of businesses. Neither will reduce the profits of lenders or retailers. Neither will increase the overall well-being of households. Instead, each will force many households to pay higher prices for an implicit subsidy to a smaller set of other households.
Society will be worse off because some people will not be able to buy products they find useful. Many others will pay more interest or higher product prices. The loss to those harmed will be greater than the gains realized by those who benefit. The net effect will be negative.
The fact that the Legislature has approved such measures attests to the economic illiteracy of voters and of their elected representatives.
Both measures would receive more scrutiny if the costs were less dispersed. Arbitrary limits on gift cards and certificates will marginally reduce the number of retailers offering such items or marginally increase prices retailers charge. But such effects are small. Though real, they won’t be perceptible to most consumers.
The economic effects of banning mortgage prepayment penalties are enormously greater than petty limits on gift certificates. Over the years, homeowners will pay hundreds of millions of dollars in higher interest costs because of this ban. But while costs will rise, most people will not understand this any better than they understand gift-card restrictions.
The economics are clear and center on who bears the risks in a loan. Interest-rate variability is one such risk. Borrowers don’t want to pay more if interest rates rise. But lenders don’t want to be locked into below-market returns if rates rise while their money is tied up in existing loans.
Fixed-rate loans eliminate risks of higher interest rates for borrowers. But the borrowers’ reduction in risk must be absorbed by lenders. If market rates rise, lenders won’t benefit, since their money will be tied up in fixed-rate loans.
Lenders thus will only make such loans if they get additional interest to compensate themselves for the risk they run. That is why interest rates on adjustable-rate mortgages usually are lower than rates on fixed-rate mortgages made at the same time. ARMs make borrowers bear some of the risk.
And that is why 30-year fixed rates are higher than comparable 15-year loans. A lender needs greater compensation to tie money up for the longer period. But some consumers gladly pay a premium for the certainty of fixed rates over the longer term.
While not as obvious, early payment of a loan also poses risk. Lend money to the government by buying a 30-year Treasury bond, and you are guaranteed to get that interest payment for the full term, even if market interest rates drop. Some people still get 13 percent interest on 30-year Treasuries purchased in 1981, even though rates quickly fell.
If, instead, you lend money via fixed-rate mortgages and rates drop, the borrower naturally will want to refinance at a lower cost. That will harm you. You won’t get the income you planned.
A prepayment penalty places some of that risk back on the borrower. If penalties are outlawed, lenders will only lend as much if they get higher rates of interest. A ban inevitably will force up mortgage rates. Broader changes in market rates may obscure such increases, but they will be real nevertheless.
Borrowers don’t like prepayment penalties. They don’t like having their interest rate go up with an ARM either, but they recognize the tradeoff for a lower initial rate. We could ban ARMs to protect people from increasing interest costs, but many consumers would be harmed by the reduced choice.
Banning prepayment penalties has the same effect – reduced consumer choice and higher costs for many borrowers. But these effects are not as obvious. It seems likely they will be enacted, but Minnesotans will be worse off as a result.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.