Robin,
Note that you can't be better off "refinancing" since your payments
continue to be $7000 a year - thus consumption never rises and your
puzzle must involve an illusion! So where is it? Run your example in
reverse. You borrow $70,000 at 10% paying $7000 per year forever. The
interest rate then falls to 7%. You thus borrow $100,000 at 7% and,
*following your logic*, you now take $70,000 of the new $100,000 and pay
off your loan giving you a savings of $30,000. Great, but wrong! You
owe the bank $7000 per year which at a 7% interest rate now has a NPV of
$100,000 - you therefore must give the bank $100,000 not $70,000. No
gain.
The key is that the NPV of the $7000 per year is $100,000 at a 7%
interest rate but only $70,000 at a 10% interest rate so *regardless* of
whether you "refinance" or not the real value of your mortgage changes
with the interest rate. Essentially, what refinancing does in your
example is to reflect the real changes in nominal terms which otherwise
would not occur.
What you should do when the interest rate goes up is save more -
that is the only source of gain.
Alex
--
Dr. Alexander Tabarrok
Vice President and Director of Research
The Independent Institute
100 Swan Way
Oakland, CA, 94621-1428
Tel. 510-632-1366, FAX: 510-568-6040
Email: [EMAIL PROTECTED]
