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Please bear with my limited knowledge of monetary systems. I've got degrees in Comp Sci and Math, and i work as an ml engineer, so I'm pretty used to numbers. But, i simply can't wrap my mind around the logic of our financial system. Is there someone out there who can help me understand whats going on?

Situation :

One can take up a loan at 1% interest rate to buy a house. (In Denmark, 2-3% in the US )

Question :

Why would anyone want to lend money at such a low interest rate?

Looking at price changes over the past 10 years, inflation is somewhere in the range 5-8% per year. I know there is something called CPI which claims inflation to be at 2% per year, but there seems to be little correlation between the CPI index and actual observed inflation.

So, i can get a loan, then buy assets with the loan, and quite rapidly inflation has eroded away the debt that i owe. And I am left with assets essentially bought to me by whoever lend me the money in the first place..

So whoever is giving me this loan is essentially giving me lots and lots of money. Why would they do this? Who is it? It doesn't make any sense to me.. When inflation is this high, the only logical thing would be for interest rates on loans to also be high?

Clarification: The 5-8% inflation is just a ballpark number i came up with. I live in a big city, and the price on everything from coffee to homes has increased in the range 50 to 200% over the past 11 years. My questions are: Are interest rates this low because lot's of investors with money want to lend their money, so when borrowing money i can get a good low rate. Or is there something else making the interest rate low? Who is it that gives the money in exchange for getting it back X years later plus 1-3% interest per year?

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    Where can you get a loan at 1% interest? – Hart CO May 11 at 16:03
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    How exactly are you estimating the inflation rate? I can't speak to Denmark's economy specifically, but 5-8% inflation seems pretty high for the values that loan interest rates are calculated against. Also, are you interested in home loans only? – Upper_Case May 11 at 16:08
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    I can't speak to Denmark, but in the US federal rates are being kept low to spur the economy, with the plan to adjust when inflation goes above target rates (~2%) perhaps your 5-8% figure is flawed. – Hart CO May 11 at 16:08
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    You seem to be asking two different questions. 1) Who is lending money at such a low rate and why would they do it? 2) Who is buying debt (e.g. bonds, CDO)? The answers to these are different. Are you really only asking one of them, or do you mean to ask both? – yoozer8 May 11 at 16:22
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    @Allan: One problem with your analysis is that the 5-8% price increase in your particular big city is not inflation, it's an increase in the cost of living IN THAT CITY. Say that city is for instance San Francisco. People move there because it has become a hub for high-paid jobs. That bids up the cost of houses, through supply & demand. Now people who provide the coffee &c for those high-paid workers need to charge more in order to pay for their housing. So the cost of living in San Francisco goes up - but it doesn't affect the cost of living in Alturas or Bakersfield. – jamesqf May 11 at 17:29
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Starting with your first question, why would anyone want to lend money at such a low interest rate?:

Look at the loan as an investment Any investment has a risk/return profile. Getting higher returns generally requires taking more risks. Safer investments, where you are less likely to lose your money, return less. Lenders are willing to loan money at a low rate because there is very little risk of loss.

You list a 1% rate on a mortgage as an example. Not every borrower will be offered that rate. There are two big factors that affect the lender's risk for a mortgage loan: the borrower and the mortgaged property.

  • The risk with the borrower is the likelihood of actually paying back the loan. If the borrower has excellent credit, good income, and reasonable savings, then it is likely that they will successfully make all payments agreed to in the contract. Contrast this with a borrower who has much lower income, or spends all their income and has very little or no savings, or has a history of missed payments. It's more likely this borrower would fail to make all the payments, or struggle to make them all in full or on time (lost job, pay cut, or unexpected expenses immediately lead to a crisis and some obligation may not get paid, and that could be the mortgage). Borrowers of the second variety would be offered a higher interest rate to make up for the additional risk. If 1000 borrowers of the first variety get a loan, and one of them fails to pay it back, the little interest from the other 999 will mitigate the loss. If 1000 borrowers of the second variety get a loan, and 400 of them fail to pay it back, the higher interest (than the low-risk group) paid by the other 600 will mitigate the loss.
  • The loan has a property as collateral. If the borrower fails to repay the loan, the lender can force a sale of the property to collect what is owed. The risk here is that selling the property may not result in enough money to cover the loss. This is why (as you've said in the comments) this rate is requires that the buyer provides a 20% down payment. This leaves room for the market price of the property to fluctuate a bit and still cover the debt. If the buyer provides a smaller down payment, the loan is closer to the full value of the property, and a dip in value (or the transaction costs of foreclosure and sale) will eat into the proceeds and not leave enough to cover the debt. As the loan is paid down, this risk decreases. Note that in some cases, the lender may require that a buyer who puts down very little cash up front pays for insurance to protect the lender from such a financial loss.

You also ask who is buying all the debt?. Speaking more generally than just mortgage debt, yes, some of it is bought by regular investors in the form of bonds, and bond funds and ETFs. Larger financial institutions, too.

The return is less than what you would see investing in other assets (e.g. stocks), but so is the risk. In theory, a loan is only given out to someone who is likely to repay it, and the interest charged is based on how likely they are to repay it (and to repay on time), so that the effect is that you are nearly guaranteed not to lose money, and to earn some small amount in interest (although it is still possible you will gain nothing, or even lose a bit). In practice, however, things like the mortgage/housing crisis we saw about a dozen years ago happen because those assumptions are not always true.

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To a large extent, central banks. In order to stimulate economies, the central banks are lending out money at interest rates that are well below the rate of inflation.

If you are a bank, and you can borrow money from the central bank at 0.1%, and then lend it to a house buyer for 1.0%, then you're making a profit.

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  • Ok, but this seems like an unstable system to me.. Like solving stiff equations with forward euler.. – Alan May 13 at 8:56
  • So if i understand correctly the system is kind of like this: (1) Central banks create money. (2) Central Banks lend out this new money at a rate much below the inflation rate. (3) Anyone who has assets can provide collateral, and will therefore be allowed to take the loan. (4) Those who can take the loan will do it, because it's essentially like getting free money. (5) This new money is then put into assets, creating asset inflation. (6) The people now have more asset value to use as collateral, so they can take up more loans. Go to (1). Is this really how it works? – Alan May 13 at 9:00
  • @Alan Where I live, house prices are still rising despite a pandemic and a recession. So there are people chasing assets using cheap borrowed money. But it's hard to do anything with this "free" money that's not inherently risky. You end up massively leveraged, and if anything you're buying goes down in value, then you risk bankruptcy. – Simon B May 13 at 12:50
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Those low interest rate home loans are tied in with the fixed income markets. In that context the question is not so much "how does my 30-year home loan have an interest rate lower than inflation" as much as it is "how does my 30-year home loan interest rate compare to the interest rates of other fixed income products". For 30-year US home loans that often means comparing with 10-year treasuries.

So who is buying? Anyone can see the appeal of fixed income, but pension funds are a perennial customer, due in no small part to the tendency for Mortgage Backed Securities to have low correlation with the Equities. Another big investor is Freddie Mac--they reported over $2T in mortgage loans on their books in their last annual report, mostly loans against single family housing. Fannie Mae likewise.

A US lender might keep that home loan promissory note on their books, or they may sell it to an investor on the Secondary Market (often securitized in some way), but ultimately there is an investor comparing the interest rate, expected effects of prepayment, probability of default, and loss severity for that home loan against other fixed income products.

The US fixed income market is the largest, but EU is #2, and much of the same reasoning applies to that Denmark home loan example as to the US home loan example. Investors look at those home loan promissory notes and associated securities as just another type of fixed income. An investor expects a return sufficiently above the perceived "risk free rate" for fixed income of a similar expected maturity (10-year Treasuries say) to make the home loan worth those extra risks, but that rate could very well be lower than recent Consumer Price Index increases and still work as an investment.

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