Addressing household debt

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Addressing household debt

The Bank of Korea’s (BOK) decision earlier this month to push the basic key interest rate to 1.5 percent has brought down bank mortgage loan rates to record lows of 2.5 percent to 2.7 percent.

In the United States, where the key interest rate stands at zero, the mortgage rate hovers around 4 percent to 4.2 percent. Korea now offers the cheapest borrowing rates for homeowners in the world apart from Japan.

Negligence in administrative surveillance and bankers’ greed is what has led to our household loan crisis. Mortgage loans are cheap in Korea for two reasons. First, the loans carry floating rates. Banks collect just the interest rates monthly and principle in lump sum when the loan matures. Some loans offered at fixed rates also automatically convert to floating rates after several years. Banks only sell this type of loan because they don’t want to shoulder any losses from changes in the lending rates. What they deal with are entirely risk-free loans. They don’t lose even though they’re offering the loans at cheap rates at the moment.

The arrangement also works well with borrowers. They think nothing of taking out loans because the interest is manageable and they can worry about principal later. Although they seek out loans using their homes as collateral, they spend them mostly for living expenses or sustaining business rather than to purchase homes. It’s why household loans keep snowballing.

The United States, on the other hand, fixes rates on mortgage loans for 30 years. If rates go higher, the risk is entirely on the banks, which have to be discreet in setting the lending rates. That’s why the rates are set between 4 percent and 4.2 percent. The principal also needs to be repaid in installments, so consumers naturally have to think twice before taking out loans.

The United States was not so careful with their lending practices before, but became cautious after learning a costly lesson during the infamous sub-prime mortgage crisis in 2008. Since then, authorities have categorized loans with floating rates as risky ones. Mortgage loans with adjustable rates now only account for 14 percent in the United States.

Banks can also be easy on housing loans with the right recourse. If the borrower cannot repay matured loans, banks have the right to claim the home as collateral, as well as other assets. With double protection, banks need not worry about losing their money, especially since the borrower is naively drawn into a “slave arrangement.”

But the U.S. bans the right to recourse other than collateral, and the borrower only loses his or her home if they cannot pay. In other words, they can keep other assets, including income, to go about their everyday lives. So banks are required to share the risk.

Korea’s mortgage loan setup should model itself on the U.S. system. It’s the only way to prevent a catastrophic spillover from the burst household debt bubble. Authorities and banks must come up with dramatically new plans to offer new mortgage loans in long-term maturity and static rate terms.

Existing loans should also be allowed to be converted on new, safer terms. Principal payments should be arranged so that banks recover it gradually, in increased amounts, during the course of maturity. The Korean government must be honest with consumers about the risks of their loans and at the same time restrict right of recourse practices by lenders.

For its part, the BOK must send a clear message to the market that it cannot cut the base interest rate any more. Consumers were afraid to fix their loans based on the expectation that there would be further cuts in the base rate. Instead, they should be warned that the rates could increase if Wall Street raises its rates.

There is no time to waste. A supply of more than 400,000 homes are on offer to the market this year. Bank counters have been packed with customers taking applications for new homes, despite the scare over Middle East respiratory syndrome. These homes will be ready to move into within two to three years, and the housing market will undergo changes due to a slimming work force. The household debt bomb could explode, and then financial and monetary authorities would have to grapple with one of the worst financial crises ever.

JoongAng Ilbo, June 18, Page 28

*The author is the head of JoongAng Ilbo Sisa Media.

by Kim Kwang-ki

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