Monday, 7 July 2008

Why homeowners don't mind inflation, except when the central bank tries to fight it.

Around 35% of Australian "homeowners" actually own their homes outright, the rest have a mortgage to pay off. For those with a mortgage, such as myself, inflation has a positive impact in that house prices tend to be underpinned by the cost of new houses in the same area - which are in turn linked to inflation. On the other hand, the mortgage principal isn't affected by inflation. Whether you may be paying off the principal over 15, 20 or 25 years, or have an "interest only" loan, inflation won't change the amount of principal owed.

This means that if the value of your home just keeps up with inflation (no real increase in value), over ten or twenty years inflation will have reduced how much you owe the bank (in real terms). For example, our house is valued at around $840,000 and we have a mortgage balance of $490,000 which will remain constant (if we continue to use an interest only loan). If inflation kept running at the current 4% pa or so, our house price would increase to approx. $1.7 million by the time I'm due to retire eighteen years from now, but the amount owed would only be "worth" $242,000 in today's dollars by then. Therefore our equity would have increase from $350,000 to the equivalent of almost $600,000 simply due to inflation.

Unfortunately, higher inflation levels are generally bad for the economy, so the central bank attempts to control it using the fairly blunt instrument of official interest rates, which in turn pushes up the interest charged on variable rate home loans. Although we fixed the interest rate on our investment property, our home loan is at the standard variable rate, so our repayments have almost doubled with the rise of inflation from 2% to 4%. For that reason a temporary spike in inflation would be better for us than a permanent shift to higher inflation rates. If inflation drops back into the RBA's target range of 2%-3%, repayments on our mortgage will trend back down towards the previous rates (although probably not quite as low as before, given the effects of the global credit squeeze), while the real value of our mortgage debt would have taken a permanent hit. Also, our salaries tend to keep pace with inflation, so a temporary spike in inflation would end up making the interest-only repayments a smaller proportion of our pay packet (although it's a bit of a struggle in the interim).

Subscribe to Enough Wealth. Copyright 2006-2008

1 comment:

James said...

Hey EW,

I hate to say it, but inflation hits everyone hard. Most of the time salaries don't actually keep up with inflation rates. Also, inflation undermines efforts to save, so if you are in an inflationary environment it can undermine any chanced you have of becoming a home owner.