Editor’s note: Today’s Post is from our PhREI Network founder, Daniel Shin MD, at The Darwinian Doctor.
This is a classic post from “The Darwinian Doctor” written in October 2018. With the market being red hot and the talk about pending inflation this post rings true… 2 years after its original release. Dr. Shin outlines how inflation actually “erodes debt over time”. My favorite line is how great the interest rates were at 5%. It is amazing that rates have dropped even lower since this post was published…. Rates actually fell below 3%. There is a lot of fear out there with this market but in reality a lot of those same fears have been present in the past. If you have a long term investing strategy then inflation in the long run will help your portfolio. I hope reading this post will bring some comfort while navigating the current real estate market.
Over time, inflation is a blessing for anyone with mortgage debt. Read below to find out why!
The effect of inflation on debt
Various sources estimate that inflation will hover around 2% for the foreseeable future. Over the history of the United States, it has averaged around 3%.
Inflation does interesting things to debt. If the debt is fixed and being paid back over a long period of time, inflation essentially erodes the debt over time.
An example from the 1990s
Here’s a very simple example to illustrate this point. Let’s say that I took out a 30 year fixed mortgage of $200k in 1990 at an interest rate of 9% (which was average for that time period). Let’s say my income in 1990 was a respectable $50k per year. My monthly payments would start out at about $1600, which is a pretty sizeable chunk of my monthly take home.
Let’s continue the scenario and say that I wasn’t too financially savvy and didn’t ever refinance the mortgage. By the year 2000, my payments would still be $1600, with about $180k of principal left to pay.
However, if my income kept pace with inflation, my annual salary would have risen to about $66k, making that monthly payment much more manageable.
This is based on historical data from the consumer price index, which is an indirect measure of inflation.
Same debt, twenty years later
Another ten years later, in 2010, I would still owe about $130k of principal out of that 200k loan. However, my salary would ideally be almost $130k, making that $1600 payment seem like chump change!
The critical assumption here is that my salary keeps pace with inflation, which isn’t always the case. But this scenario does show that in general and over time, goods and services cost more and more dollars for the same thing. Therefore, fixing a payment in place over a long period of time (and at a reasonable interest rate) usually makes that payment proportionally less and less in comparison to the cost of everything else (and your income).
An era of historically low interest rates
This same scenario would be even more favorable now, in 2018, with mortgage interest rates still comparably lower than historic norms (less than 5% at the time of writing). Did you know that in 1981, 30 year fixed mortgage rates in the United States briefly touched 18%? What a difference!
When looked at in this light, inflation certainly seems like a blessing. Real estate investors have been locking in low interest rates like crazy since the Great Recession because of the phenomenon outlined above.
What if you’re not an investor in real estate or don’t have a mortgage in place on your primary residence? Then depending on how you’ve decided to invest your assets, inflation can be a real danger to your long term financial well being.