How Inflation Benefits Borrowers and Mortgage Holders
Inflation is an economic phenomenon that affects the purchasing power of money. It is essential to grasp its implications for borrowers and lenders, particularly in the context of debt. This article delves into the impact of inflation on debt over time and how it benefits Canadians who carry a lot of debt. By understanding this process, individuals can make informed decisions regarding borrowing and lending.
How Does Inflation Work?
Inflation refers to the general increase in prices of goods and services in an economy over time. When inflation occurs, the value of a currency decreases, meaning that the same amount of money can buy fewer goods and services. It erodes the purchasing power of money, affecting both individuals and the broader economy.
How is Inflation is Bad for the Economy?
Inflation can have several negative effects on long-term economic growth. Here are some reasons why inflation is generally considered detrimental to economic growth:
Every day purchases become more expensive: Inflation erodes the power of your money over time.
For example, if inflation is 5%, as it was recently, then a shopping trip that cost $100 at the beginning of the year would cost $105 by the end of the year and if the same rate of inflation persisted then after two years the same shopping cart would cost $110.25.
As prices rise, people and businesses can buy fewer goods and services with the same income. This leads to a decrease in “real” income (i.e., your pay hasn’t dropped, but the value of your pay has dropped). When people have less buying power, they spend more of their income on day-to-day expenses and have less disposable income to invest or save. This reduced investment acts as a drag on economic growth.Uncertainty and instability: High or unpredictable inflation creates uncertainty and instability in an economy. When inflation rates and prices are volatile, it becomes challenging for Canadians to commit to long term decisions. Uncertainty about future prices makes it difficult to plan for the future, make long-term plans.
For example, many people would hesitate to commit to an all-inclusive vacation in two years if they don’t know what it will cost and, because of inflation, it could be 10 or 20 per cent more expensive than it is today.
This uncertainty can dampen economic growth by discouraging big expenditures and creating a general sense of instability.Distorted price signals: Inflation distorts price signals, making it harder for market participants to accurately gauge supply and demand dynamics. When prices are rising rapidly, it becomes challenging to differentiate between a demand driven price increase and a general universal increase in the price of all things.
For example, 2023 real estate demand has been lower than in previous years, but supply has dropped even further. Home prices have risen dramatically, but is it because of broader economic inflation, housing demand in my specific neighbourhood, or have people been overpaying because it’s difficult to know the true value of assets when prices are so volatile?
This difficulty gauging what is a good price can lead to overspending in certain areas, people may invest in assets that appear to provide good returns due to inflated prices but the returns are not sustainable in the long run. Distorted price signals hinder our ability to make effective investment and spending decisions which are essential for the long-term growth of personal wealth.Reduced savings and investment: Inflation can discourage saving and long-term investment. When the value of money erodes over time and often inflation is higher then the interest earned on savings, people are incentivised to spend or invest their money rather than save it. This can lead to decreased savings rates.
Savings and investments are crucial for funding investments Canadian infrastructure like highways, bridges, and fibre-optic networks as well as investment in business expansion that creates jobs. Reduced savings and investment can limit the Canadian economy's capacity to grow and innovate over the long term.Negative impact on retirees and pensioners: Inflation can be particularly harmful to individuals with fixed incomes, such as retirees or pensioners. They receive a fixed amount of monthly spending money from their pensions and benefits and from drawing on their retirement savings. When prices rise, their purchasing power diminishes. Their living standards drop, making it more difficult for them to maintain their lifestyles, help their family, and participate in their community in the way they’ve become accustomed to. Since this has a greater impact on retirees, it leads to greater generational inequality.
It's important to note that a consistent and predictable moderate level of inflation of around 2 per cent is generally considered normal and even beneficial for economic growth. It can help stimulate consumption, investment, and economic activity. However, persistently high (i.e., above 3%), persistently low (i.e., below 1%), and volatile (i.e., seesawing between high and low) inflation rates can have detrimental effects on long-term economic growth. The Bank of Canada is independent from the elected government, to reduce the chances of political interference, and its primary mandate is to maintain low and stable inflation to support sustainable economic growth.
The Benefit of Inflation for Borrowers
When inflation takes place, the value of money decreases over time. Canadian mortgages are valued in Canadian dollars, so the value of the balances on their mortgages gets devalued when there is inflation.
Let's consider a practical example. Suppose you borrow $500,000 from a lender to buy a house and agree to repay it in one year. If the inflation rate during that year is 10%, the value of the house should have increased to $550,000. When it's time to repay the debt, you will still have to pay back $500,000, but the value of that loan has decreased due to inflation. In other words, the lender will be repaid with dollars that have lost some of their purchasing power. If the lender, after being repaid, tried to loan the money to someone else the $500,000 loan would allow the new borrower to buy a home 10% less valuable than yours.
As well, in an ideal world, your salary has increased by 10% over the same year so the financial burden of repaying the loan is 10% less.
The impact of inflation on debt is especially relevant for long-term debt obligations, like mortgages that are repaid over 25 to 35 years. If inflation remains persistent over an extended period, the erosion of the debt's value can be more significant. Lenders are aware of this inflation risk, which is why interest rates on mortgages often include an inflation premium to compensate for the potential loss in real value over time.
Inflation is High, Should I Take on Mortgage Debt?
Understanding how inflation devalues debt is crucial for mortgage holders and prospective home buyers.
As inflation erodes the buying power of money over time, mortgage repayment dynamics are significantly affected.
Borrowers may find themselves repaying the original mortgage amount (i.e., principal) which has diminished in “real” value. Lenders must account for the potential loss of purchasing power, but that’s not the borrower’s problem.
If inflation were 10% annually for 7 consecutive years the price of your home will double, but the value of the mortgage and its repayment trajectory will have remained unchanged. If we say that the economic and social value of the home is unchanged, then the effective value of the mortgage has halved.
While inflation is high today, we don’t know how long it will remain high. In hindsight, taking on debt before the pandemic would have been a brilliant, and likley stressful, move.
The Bank of Canada and central banks globally have all increased interest rates to bring it back down. On July 12, The Bank of Canada today increased its target for the overnight rate to 5% and also continued its policy of quantitative tightening.
The Bank also said further interest rate increases may be needed to combat inflation. It seems clear that, if The Bank of Canada has it within its power, inflation will be back down soon.
However, inflation is currently 3.4%, if inflation for the next two years is 3% and you take out a $500,000 HELOC* and only repay the interest then in two years that loan will still be $500,000 but because everything will be more expensive it will feel like its a $471,000 HELOC.
For a rental investment, where the rental income can increase with inflation, this inflationary dynamic can make a rental investment very attractive.
The factors at play are complex and knowing exact conditions that make using inflation to your advantage is difficult. The information provided in this article is for informational purposes only and should not be considered as financial or investment advice. Before making any financial decisions or taking actions, it is recommended to consult with a qualified wealth advisor or financial professional who can provide personalized guidance based on your specific circumstances and goals.
* HELOC: A home equity line of credit (HELOC) is a line of credit that uses the equity you have in your home as collateral. It is similar to a conventional mortgage, except a mortgage requires that you pay interest and also pay down the balance of the loan, whereas a HELOC only required that you repay the interest.
