By JLP | September 16, 2010
Mark’s comment on yesterday’s post inspired this post. Thanks, Mark!
I have written about the impact of inflation on mortgage payments in the past (see: Your Mortgage May Not Be As Expensive As You Think It Is). The problem with old posts is that they get buried and no one ever reads them again.
The companies (and certain radio and TV personalities) that talk about mortgages and how much interest you pay, aren’t telling you the full story. If you buy a house with a $200,000 mortgage with a 4.75% fixed interest rate for 30-years, they will tell you that you will pay nearly $160,000 in interest alone! In absolute dollar amounts they are correct. But, they are also very wrong because they are not factoring inflation into the equation. Why is inflation important? Well, for several reasons:
1. Inflation usually means that prices will go up over time.
2. Inflation can lead to cost-of-living adjustments (increases) to wages.
3. Meanwhile, the amount you pay on your fixed mortgage stays the same.
What this means is that your payment—although it stays the same dollar amount throughout the mortgage term—it decreases over time due to inflation.
Of course it depends on the inflation rate. The higher the inflation rate, the cheaper your fixed mortgage becomes over the years. For instance, check out the following four graphics I put together. The first two represent a 30-year mortgage. The first one is with a 3% inflation rate and the second one is with a 4% inflation rate. Notice the difference between the total amount of interest paid and the total amount of interest paid NET inflation. Pretty sizeable difference.
For those interested in 15-year mortages, I ran those numbers too:
How did I arrive at these numbers? I did what’s called a discounted cash flow of the mortgage amortization. This is where you take each payment and discount it at the expected inflation rate. You can read Your Mortgage May Not Be As Expensive As You Think It Is to get the math.
What can we take away from this? Well, for one, with interest rates on mortgages as low as they are right now and inflation expected to rise in the future, you might be better off keeping with a long mortgage. The higher the inflation rate, the cheaper borrowed money becomes (as long as you have a good interest rate on the loan).
Those who adamantly suggest that people pay off their mortgages as quickly as possible are missing the big picture.