Mortgages vs. Inflation

April 24, 2013 No Comments »
Mortgages vs. Inflation

Mortgage match-ups: “Mortgages vs. inflation.”

While inflation has been kept mostly in check lately as the economy has limped along, many economists expect it to rise significantly in coming years as things get back on track.

At the moment, both inflation and interest rates are very low because the economy is in the dumps, but what goes down must eventually come back up too.

Inflation is a tricky concept to wrap one’s head around, but it’s basically defined as the increase in the cost of goods and services over time. Or a decline in the purchasing power of money.

One may also look at it as a money supply that has grown too large, which can push prices higher and higher, eventually outpacing wages and creating big problems.

The Fed essentially controls the money supply by raising or lowering rates, which contracts or expands supply, respectively.

Currently, interest rates are low to accommodate growth.  This is good for borrowers (who can qualify for mortgages), but bad for savers, which I’ll explain later in the post.

There’s a lot more to the story, but to keep things simple, as inflation rises, the value of our dollars today will be diminished tomorrow.

Essentially, that $100 you have in your bank account won’t be worth $100 in the future. Or it won’t buy you what it once could. Instead, it will lose value, or purchasing power, over time, thanks to inflation.

This is pretty much a given, though inflation rates do fluctuate over time. And there are even periods of deflation.

Remember when Grandma told you how much she could buy with a nickel back in 1928? That’s inflation.

Inflation Can Hurt and Help

Most individuals look at inflation with disdain, but it can actually be beneficial, depending on your circumstances.

For savers, inflation is a foe – it devalues your money, and thus anything saved and earning a paltry amount of interest may actually lose real value.

Sure, that $100 you put in a bank account may turn into $120 in a few years, and you may pat yourself on the back. But what will $120 buy you in the future? Probably not as much, which is why socking away money in a low paying savings account isn’t as advantageous as it may seem.

So some savers may turn to more attractive investments, such as the stock market, where annual returns can beat the annual inflation rate.

As a result, their money may actually increase in value, instead of simply keeping up with or falling short of inflation.

For the record, those who keep money under the mattress, earning no return, lose out completely to inflation, assuming it occurs.

Additionally, those who rent as opposed to buy are hurt as well because rents rise with inflation, whereas mortgage payments are often fixed, no matter what inflation does to our dollars.

Fixed Mortgages Combat Inflation

So who wins exactly? Well, those who hold long-term fixed debt of course, such as 30-year fixed mortgages. As noted in the preceding example, money loses value (purchasing power) over time.

If a homeowner buys a house in a given year with a $100,000 mortgage, the original loan amount will lose value over time. That $100,000 won’t actually be worth $100,000 in future dollars.

Using a future inflation calculator, we can get an idea of what that original mortgage balance will actually be worth in say 10 or 15 years. Assuming a 3% annual inflation rate, the $100,000 loan balance would only be worth about $74,000 in 10 years.

In 15 years, it drops to about $64,000, meaning your loan balance won’t really cost you as much in future dollars.

Put another way, you’ll need about $134,000 in 10 years, or $156,000 in 15 years to equal the original $100,000 investment made in your home.

So if you still have most of that mortgage balance a decade from now, it won’t be as much of a financial burden. After all, if time really does erode the value of money, the remainder of the $100,000 won’t have the same value it once did.

In other words, paying it off in the future will be easier. And as inflation rises, so too should salaries, so if you’re making more money and dollars are worth less, that $100,000 balance will be a lot easier to tackle.

With more money in your pocket, and a fixed mortgage payment that hasn’t changed for a decade or longer, you’ll be looking at even more “affordable” monthly payments.

For example, a $1,000 monthly mortgage payment 10 years from now will really only cost about $750. So going nuts and trying to pay off your mortgage early and as quickly as possible may not be as attractive as you think it is.

Sure, the prospect of inflation doesn’t mean you should carry balances forever and ever, but with mortgage rates this low and inflation on the horizon, it changes the equation quite a bit.

Just note that this only really works for fixed mortgages.  As inflation increases, interest rates will rise to combat it, and that means higher rates on adjustable-rate mortgages and all other types of loans. So locking in a fixed rate mortgage today is probably the wiser move.

Read more: Pay off the mortgage or invest?

(photo: Donnaphoto)

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