European banks, low interest rates and "free money" for home owners?

Question

Where I live in Scandinavia and across Europe, interest rates are very low.

More and more people are using the rising value of their home to draw out money. I would almost call it "free" money when the interest rate is near 2%.

Case in point: I just saved over 2 years the money to renovate my kitchen.

In contrast, my neighbour borrowed 30,000 euro against his house (whose value keeps going up) to renovate his bathroom. He borrowed another 70,000 euro for a new car. He telephoned the bank and easily got the money.

When we talked about it, his point was that he got the new bathroom 2 years earlier than if he had saved up the money. He doesn't seem concerned about pushing out the end date of his mortgage or possibly never owning 100% equity in his home.

Perhaps I'm overlooking something. I can't see any economic benefit to borrowing against their houses to buy new Teslas, bathrooms, kitchens and sailboats. Mostly "toys" and "luxuries", if you will - all financed by the national central bank.

I wonder, where does all this money come from? His bank gets loans from the national central bank but where do they get the money from? Can central banks just "make up" loans from nothing?

Answer 1

Yes the central bank can make money out of thin air. However that isn't what is happening. For the past 10 years or so countries have been participating in Quantitative Easing (QE). This basically gives regular banks lots of money to allow for the type of behavior you mentioned. Basically the government goes into debt to "create" easy money, so it stimulates the economy. Eventually they will have to stop doing this and debt will not be so easy to get. Ending the process is called Quantitative Tightening.

The intended purpose is it gets people out there spending money, and stimulating the economy. This exact method is relatively new so no one really knows how it will end exactly, but I don't see it ending well.

I tend to agree with you that it is a dumb policy that allows people to buy things they usually wouldn't be able to afford. The people who will really get the short end of the stick are people with long term variable rate loans. As interest rates go up so will these loans, and more people (not all) will eventually default on them.

Answer 2

Is the part of Scandinavia you are talking about part of the EU?

In case it is, the EU Mortage Credit Directive which came into effect around 2016 should put pretty strong limits to that practice.

To put it in as short and simple as possibly words: It's nice if you get a loan to buy yourself something nice, but after all, you will have to pay it back. And an extremely stupid thing is to finance a toy (car, boat) with a load that lasts way longer than the asset you bought with it.

Answer 3

The money comes from the ECB.

It's an explicit policy of the ECB to drive up inflation. The ECB believes the inflation should be higher, ideally close to 2%. It's currently low. Conventional wisdom is that the inflation is low because people aren't spending. Another conventional wisdom is that low interest rates increase spending.

Well, at least the latter theory seems to be confirmed by your neighbour. The lack of inflation is probably because the assumed interest-inflation correlation doesn't actually exist anymore. A likely culprit is that the correlation was caused by a third variable, namely wages. Recent wage increases seem to be in line with inflation, i.e. near zero. Shops simply cannot raise prices as consumers don't have more to spend each month.

Answer 4

where does all this money come from?

This is a common confusion: When you borrow money from a commercial bank it is not actual money from other people/sources you get. Instead the money is created via a booking trick. You get, say $100 credit to your account but at the same time you get a $-100 as debit to your loan account. So in sum there is zero money. This money is called bank money or demand deposit. This money exists only as long as the demand exists and is "destroyed" once you pay it back or default on you loan.

To limit the inflation of the money supply, the Banks are required to hold a certain fraction of the money as securities in real money (assets, deposits, central bank loans, etc.).

This is called fractional reserve banking.

Can (central) banks just "make up" loans from nothing?

Yes, hence it is called FIAT-Money. The term fiat derives from the Latin fiat ("let it be done") used in the sense of an order, decree or resolution. In contrast to hard currency like Gold (or Bitcoin, as a concept), which have to be mined, so the Supply is limited.

This has its advantages and disadvantages. For example, In a FIAT Money system, supply of money can be expanded with the growth of the economy. On the other hand, if people loose trust in the money politics, it can essentially become worthless over night.

Is it wise to loan if its "free"?

As the money market is largely influenced by the prime rate and the reserve requirements, which are subject to change depending on politics, it is generally advisable to have as little debt as possible from a security perspective. So it all depends on you personal risk appetite.

It is also important to distinguish between spending and investment. The things your neighbors buy, seem to fall mostly in the spending category, which makes them a loss even at zero interest rate.

Whereas a house which saves you rent, could be considered an investment. More of, once you paid that off you can start to invest and earn interest yourself.

So in the end, you neighbors will have to work more for their luxuries than you with your frugality, even if all goes well. So a matter of personal taste if you are willing to work for luxuries or value your free time more.