Some assets perform better than others during periods of inflation. The question many homeowners have is how their investment in their home will fare during times of higher than normal inflation.
Inflation can help homeowners in two ways.
Inflation reduces the real value of their mortgage.
It may also increase the value of their home.
Inflation is a homeowner's best friend
Or to be more precise, inflation is a “mortgage owners” best friend. To fully understand why this is the case we need to understand three concepts.
Inflation
Nominal interest rates and;
Real interest rates
Inflation is the rate at which the prices of goods and services in the economy are rising, which reduces the purchasing power (what you can actually buy with a dollar) of local currency.
If we say the inflation rate in the United States is 2% this year, that means the general price of goods and services in the U.S has increased by 2%. Or looking at it the other way, the purchasing power of a U.S dollar to buy local goods has decreased by 2%.
Nominal interest rates are the rates advertised by the bank. If the bank approves you for a mortgage with a 4% interest rate, they are referring to the nominal interest rate on your loan.
The real interest rate is equal to the nominal interest rate minus the rate of inflation. If the inflation rate in the economy is 3% and the nominal interest rate on your mortgage is 4%, your “real” interest rate is 1%.
Suddenly that interest rate isn’t looking too bad.
Inflation will pay (some) of your mortgage for you
In a previous article, I wrote about how inflation hurts savers. The opposite is also true, inflation helps those in debt. If your nominal debt is not increasing, inflation will lower the real value of your debt over time.
Consider an extreme example to show how this works.
Let’s say I have a $300,000 mortgage and I make interest-only payments for the next 30 years. Meaning I still owe $300,000 on my mortgage 30 years from now. I have not paid a single penny in principal.
At first glance, this is a very depressing outcome. I still owe the same amount of money as I did 30 years ago. Of course, that is not really true.
While I owe the same amount in “nominal” terms, $300,000 my debt in “real” terms would only be $136,425 if inflation averaged 3% per year over the past 30 years.
I was able to cut the real value of my debt in half without making any payments against the principal. Inflation did all the work for me.
To put it simply, $300,000 in 2050 will be worth less than $300,000 in 2020.
Whenever there is a change in economic conditions there will always be winners and losers. When inflation increases those with money in savings accounts are the losers and those with large levels of debt (homeowners) are the winners.
How inflation impacts real estate prices
Inflation increases the price of goods throughout the economy, which typically includes real estate.
The reason inflation increases real estate prices is simple economics.
Inflation will increase the cost to construct new homes.
Real estate developers will try and pass those increased costs to the consumer.
The increase in the price of new homes will increase the demand for existing homes as buyers look for an affordable alternative.
Holding all other factors constant, the increase in demand will lead to an increase in the price of existing homes as well.
A word of caution
Even though the real value of our mortgage is declining due to inflation, holding high levels of debt is still presents risks.
Risk 1: Inflation Eats into Wages
If my wages don’t keep pace with inflation over the next 30 years, my “real” income will be declining and my ability to service any amount of debt will be compromised.
Risk 2: Interest rates rise
Historically speaking, interest rates are very low in 2019. There is a lot more room for interest rates to increase than decrease in the future. If nominal interest rates rise faster than inflation, that is bad news for people with large debt loads.
If you have a fixed-rate mortgage, this may not be as much of a concern. However, if you have a variable rate mortgage or you are refinancing or renegotiating the terms of your mortgage, your interest rate and mortgage payments could increase.
Risk 3: Increasing our debt loads
The most significant risk in taking my time to pay off my mortgage would be the temptation to refinance my mortgage and borrow even larger amounts of money.
If I said, “it’s okay if I double my mortgage, inflaton will take care of it”, I would be setting myself up for financial disaster.
Bottom line
It’s important to understand how changes within the economic impact our personal finances in different ways. High levels of inflation create winners and losers throughout the economy.
The losers being those with large amounts of savings and the winners being those with large amounts of debt. Homeowners with fixed-rate mortgages would likely benefit from inflation.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions
How did you calculate the $136,425? Coulf you please share the formula.