How Inflation Helps Homeowners
If you listen to financial “gurus” like Dave Ramsey you may have heard them say that putting 100% down on a home is a good financial decision.
Setting aside putting 100% down on a home is not an option for 99% of the population, I want to address why I would never put 100% down on a home even if I had the money to do it.
In fact, from a financial perspective, in the right circumstances, it makes sense to hold onto your mortgage for as long as possible.
Inflation is a Homeowners 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.
- 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 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 true 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 principle.
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 principle. Inflation did all the work for me.
To put it simply, $300,000 in 2049 will be worth less than $300,000 in 2019.
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.
Opportunity Cost of Aggressively Paying your Mortgage Off
Returning to our example with a 4% nominal mortgage rate and inflation of 3% which corresponds to a 1% real interest rate.
If I can find an investment that will reliably pay me more than a 1% real rate of return, I would be made better off minimizing my mortgage payments and maximizing the amount I invest.
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 too
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 faster than Inflation
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.
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, inflation will take care of it”, I would be setting myself up for financial disaster.
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.
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