Inflation: Mortgage Friend of Foe?
Inflation has a rather nasty connotation… people think of it as this horrible entity that steals from your bank account in the dead of night… and in some regards… that’s true! But what if I said it could also do the opposite… there are two sides to this inflation story.
First let’s define what inflation is, it’s basically a “general” rise in the cost of goods and services of a nation. What it isn’t: it isn’t a black and white measurement of the value of the dollar. What I mean by that is just because there is inflation doesn’t mean your money is worth less in every instance. You can for instance buy a gallon of gas for a lot less than you could a few years ago, you can also by a 4K television for less as well (so your dollar is actually more valuable in those instances). Inflation just means that most of the common stuff you buy everyday, on average, has become more expensive and it takes more dollars to buy those things… on average.
Because inflation is typically measured by a nations currency, there is a common misconception that inflation is only caused by the government that produces that currency. While there is no doubt that those printing the money are a major factor in the facilitation of inflation, it’s important to realize that there is another force that is creating and destroying money as well. If you hadn’t guessed already…. they’re called banks. I don’t think people realize the power of the banking industry on our economy or that banks essentially print their own money. Hey,,, isn’t the government the only entity allowed to print money? Well, sort of…..
The Fractional Reserve Rate
There’s this thing called the fractional reserve rate where the government says a bank has to hold onto a certain amount of its deposits, but can lend out the rest. Currently that reserve rate is set at 10%, so if you put $1,000 in the bank,,, the bank can lend $900 of it to somebody else. If that somebody else puts their newly acquired $900 in their bank, that bank can lend $810 of that money to somebody else… and so on and so on. Even though the government only printed out $1,000 in cash, one guy has $1,000 in his bank, and another guy has $900, etc. Weird, I know.
As you can probably imagine this doesn’t always end well when everyone wants their money back at the same time (think Great Depression). But in times of heavy lending (good times) this leads to an increased money supply, at least on the books of banks, and more and more money leads to more and more inflation. Basically when money is easier to get, the price of goods and services rise. But why?
How Inflation Happens
A good example of this was in one of my favorite books, The Floor of Heaven: A True Tale of the Last Frontier and the Yukon Gold Rush. In that account of the Alaskan gold rush a major find was made in a remote area of the Klondike, and newly wealthy miners were snowed in for the winter there. All of the sudden the price of goods and services rose at an astonishing rate. In one anecdote a can of peaches sold for the equivalent of $10,000 in today’s money. Peaches surely would have cost more in such a remote region because of the low supply and high demand. But it certainly would not go 10,000 times higher than normal without all that new money being introduced. The reason it went 10,000 times higher is because there was so much gold in that tiny town, and everybody had it.
Why you Should Care
So why do you need to worry about inflation anyway? Well, I think this is important to understand because right now we have a relatively low inflation rate. The inflation rate has been under 3% since 2012 and is much more likely to go up 3%, than down by 3%. When inflation remains at these low levels for a long period of time banks lower the rates that they lend at. Right now for instance, inflation is almost 3% and banks charge about 4% for a 30 year mortgage.
Inflation May Help You
What happens if inflation rises past 4%? Well, let’s say the only debt you have is your mortgage, and inflation increases more than the banks expect, let’s say it rises to the levels it was in the 1970’s, we’re talking over 10%. Well, assuming you still have a job, you should actually be pretty darn happy. Happy stuff is getting more expensive? Am I crazy?
Yeah, you heard me right. Basically if you are buried in debt that has a fixed payment, inflation can be your best friend. Higher than expected inflation typically benefits the borrower, not the lender. Don’t take my word for it: Investopedia. Think of it this way, if you have a $300K mortgage at 3% APR and inflation goes up to 10%, then you are locked in at 3% and get to repay the loan with less valuable dollars.
Let me drift into hyperbole for a moment to better illustrate this. Let’s say your mortgage is locked in at $1,000 a month, that’s $12,000 a year. It’s a fixed rate loan and will never go up. Let’s say your salary is $100,000 a year; that means 12% ($12,000) of your $100,000 income goes to the mortgage every year. Still with me? Now let’s say inflation rises to 10% and stays there for 7 years. Taking into account compounding interest and assuming salaries kept up with that inflation, your new salary would now be $200,000 per year, and your $12,000 mortgage would now only be 6% of your $200,000 income. You are paying back your mortgage with dollars that are worth half what they were 7 years ago. The bank did not plan on the dollar being that weak when they locked your rate.
Rethink Paying off the Mortgage
This is just one more reason why you are likely better off investing your money in other things that will return you greater than a 4% return in the long run, rather than paying off your historically low 4% APR mortgage. Paying off your house is great,,, but right now investing that money in an investment that does better than your 4% APR mortgage might make more sense,,, and that is actually pretty easy to do over the long run…. (Read: The Easy way to Invest Money and Consistently Outperform Hedge Fund Managers) Also, if you don’t have a low interest rate and are still paying on a 6% mortgage from 10 years ago…. Please… Seriously… You need to look into refinancing to a lower rate now.
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