*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.

How much?

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.

This analysis makes sense with a big IF built into it. That IF is that your wages keep pace with inflation over the life of the loan. That will be the case with some workers but not all, particularly older workers. Otherwise, with increasing inflation, that mortgage payment gradually becomes a larger percentage of your spending power.

GoTo,

I think over time, wages do tend to increase. Regardless, prices are going to rise, making the mortgage payment “cheaper” in comparison.

Thanks for all your blogging attempts to educate me, but I’m still going for it, JLP! (And it’s happening Monday! ๐ It seems you don’t agree, but I’ll be content that my pmts can be “cheaper” in years 10, 11, 12 from inflation. I’ll just skip over the years 13-30 and not lose any sleep over what “could have been.”

Then I will have a mortgage burning party in my PAID OFF HOUSE and I’ll treat you to some beers and we can reminisce about the mistake I made! (Hopefully cd interest rates will still be less than 2%.) In the meantime, if/when inflation rears its ugly head, hopefully it also affects my home value so my equity is even higher!

I may not imbibe the Ramsey Kool Aid about 12% returns, but I am a firm believer in not having debt later in life. If anyone wants to send me a dollar I’ll happily send back .25-.36!! It’s the deal Uncle Sam gives us every day…

Who knows what will happen in the future? Any financial planning is likely to be wrong. We just make the best decision we can w/the facts and assumptions at hand and move forward, right?

@JLP: First – I’m very glad my comment inspired this post. I am quite frugal and conservative, and I like to get the best deal on everything. Sometimes I discover that when I run the numbers, the best deal isn’t what “everyone” thinks it is.

Your last example is the best of all. If the interest rate is lower than the inflation rate, you are paying NEGATIVE interest.

@Mr GoTo: I fully agree that it may depend on the individual. Perhaps an older person shouldn’t have a mortgage at all?

I read an interesting article some time ago about how borrowing is a way of smoothing your lifetime income and consumption patterns. Essentially, a mortgage allows you (for a price) to tap your future earnings before you receive them. Many commentators throw up their hands in horror at this idea, and many consumers take it to extremes and face the consequences, but I think there is a case for a certain amount of debt at an early age, especially if it is at a low rate and subsidized by the government.

@Stacey: The decision to be debt-free is not wrong. But it is important to realize that you are doing it for your emotional (not financial) well-being. Just as risk-tolerance is personal, so is freedom from debt.

Stacey,

I have tried to make it my “job” to throw the information out there. To try to look at things differently than you’ll find in magazines and stuff like that. I post this stuff in an effort to learn and share. What you do with it is up to you.

There’s the numbers side and the emotional side. I certainly can’t fault a person for wanting to be debt free. I just want to make sure people aren’t using emotions, but thinking they are using numbers…lol.

Great example of the effects of inflation and mortgages. I always talk about my parents who bought a home in 1972 for $26,500. As my Dad made the last payments, it was laughable how little it cost him in 2002 dollars. It was less than a car payment. However, when he bought the home, he had to work two jobs to make the payments.

If you believe we will experience high inflation, then take out as much debt as possible so you can increase your wealth as JLP shows.

Of course, deflation is a real concern too. It may seem counter-intuitive considering the massive debt and zero percent rates, but that is what Japan thought too. They are on year number 20 with deflation. In this case, pay off the debt as fast as possible.

Ultimately, it is a personal decision. I can’t argue that paying off or not paying off is a bad move. Both have positive aspects so do what you feel is best for you. Stacey will have no debt and will sleep soundly at night so paying off the mortgage is a good move for her.

Just keep your debt to assets ratio at a healthy range for your age, and you are all set.

Thanks for the comment, Kirk.

The thing is, mortgage rates are market based too. I believe in the ‘Efficient-market hypothesis’ — meaning that today’s mortgage rates have already priced in expected future inflation. Then again, we may be living in irrational exuberance in the bond market keeping mortgage rates artificially low.

Ah! What is one to do?

(good point Kirk on the Japanese style deflation scenario being the killer to this plan)

@BG: Mortgage rates are most definitely market-based, and have priced in the conventional wisdom regarding inflation. They have also priced in the fact that the average American moves every 7 years or so, which means the banks know that (on average) they are not really making 30-year commitments.

If deflation does kick in, you can always refinance into an even lower interest rate, or pay off. The 30 year fixed simply gives you an OPTION to borrow money for an extended period. If you move, refi or pay off, the option goes away.

Markets are always efficient … except when they are not! House prices in 2005, 2006 and 2007 were market-based – they encapsulated the conventional wisdom that housing was a good investment because it always went up. Was the stock market correctly priced in March 2008 or March 2009? In both cases, all future expectations were priced in.

Our current situation is one of irrational pessimism to average out the irrational exuberance of the previous few years.

The big difference between the US and Japan is that they are net exporters. They have had very brief periods of trade deficits (1979 to 1980, and a few months in 2009) but otherwise run a surplus.

Our model may be more like Greece and other countries that are net importers. Greek ten-year bonds yielded 5% in October 2009, and are now around 10%.

“Inflation and Your Mortgage”

Excellent post by JLP.

There are many, many personal finance blogs, newsletters, columnists, magazines, etc. available, But very few even mention Inflation in their advice and calculations. Inflation is a huge issue, and it is amazing how most professional financial experts ignore it completely.

I would like to see more posts on Inflation and Your Money.

Terry wrote:

“Excellent post by JLP.”Thanks! Every once in a while I write something interesting…lol.

Please, if you read something you think is worth sharing, share (digg, reddit, stumble, tell your friends, etc.). Word-of-mouth helps tremendously in the blogging world.

Mark,

You are right on the money. Thanks for your comments.

BG wrote:

“…we may be living in irrational exuberance in the bond market keeping mortgage rates artificially low.”I think this is exactly right.

I always go back and forth on the paying off the mortgages issue, partly because of the information in this post. My wife and I are in the process of trying to pay off our loan as fast as reasonably possible, but every time I read an article like this, it makes me wonder if it’s the right decision. I realize the advantages of being debt free, but there opportunity costs, such as not having that money in the market if there is a big rally. It all comes down to what your goals are.

I’m not trying to have the last word or anything…and most likely won’t! ๐

My husband is 47, so our house will be paid off when he’s around 60. He has great income potential now, but is surviving his 2nd buyout of employer…who knows when he passes that magical 55-mark if he’ll continue to be desirable to others (he’ll always be desirable to me!)

Fact: We want to time finishing the kids’ college and house obligations around the same time.

Fact: we haven’t been pleased w/our 529 returns or our 401k/IRA returns over the 10-20 years we’ve been slogging thru it. Thank God for employer matches…Now we’re sufficiently in Retirement Age funds, indexes, etc. We’ll see what the market can do…And there’s always my fav P&G which will hopefully light on fire eventually…or at least the dividends will help when/if inflation appears.

Fact: At husband’s career end we most likely will not be able to itemize efficiently, except for bunching charitable contributions off and on between years.

Fact: We have a healthy cash cushion (could always be higher), so that facet of our portfolio is not neglected by accelerating the mortgage paydown. We also have I-series savings bonds to help ride any inflation wave.

Conclusion: I have crunched the numbers and it is a financial decision (w/ a dash of emotion). Inflation may be high, it may be low. If I had a crystal ball I’d know if inflation was going to be 5%. But I don’t, nor does anyone else. And 3.875% is a damn good rate on a (gulp) large mortgage for a large house. So I’m betting on the sure horse in my life and that’s bidding adieu to the debt.

And if inflation is high, then I’ll finally get some decent cd rates and my house value will increase. I’ll sell it around age 65, (hopefully the IRS is still allowing non-taxable cap gains on home sales) and take my tax-free $1 million+ proceeds and ride off into the sunset to a cinder-block nursing home.

In the meantime if I had invested the difference, those investment gains would be taxable (and taxed higher thanks to healthcare reform 3.8% thank you very much), my itemized deductions may or may not have exceeded my standard deduction, yada, yada, yada, what I wrote yesterday.

So it all depends on one’s personal situation and preferences. For me it’s a no-brainer as it accomplishes what WE need to have happen.

Good post!

I agree with Mr Goto. Most corporations have a grading scale for exempt employees in which employees in the 40 – 65 age range can hit the top of the payscale, if they are not moving up in management, and thus receive either no pay raise or a slight 1 or 2%.

I prepared a cash analysis of paying your house off early vs investing using median home price range in my city, no inflation. The difference was $75k positive if you invested. For $75k I’d rather have the piece of mind for many years knowing I have no debt vs one more year of retirement.

OK, I’ve thought about this some more:

It is a 100% guarantee that the 15-year mortgage beats the 30-year mortgage in month #1. The inflation rate is guaranteed to be less than whatever mortgage rate you can get for the first month. Today’s mortgage rates are 3.8% (or so), and the published inflation number is 1.24% (for July ’10).

What this means is that the 15-year mortgage, starts the game ahead of the 30-year mortgage on month #1, guaranteed. The question becomes: how many months/years will it take before inflation turns in favor of the 30-year mortgage? And once the high inflation hits: how many months will it take the 30-year mortgage to make up the ground it lost to the 15-year mortgage at the beginning of the simulation?

Picking the 30-year over the 15-year is a losing strategy right out of the gate — but is it a faster horse in the long run?

JLP – thanks for illustrating why DEflation is so scary!

As a home owner who is *not* living on a fixed income, I prefer moderate inflation. ๐

We just put an offer in on a house. The payment will stretch our budget (but hopefully not break it). I’m counting on inflation and (modest) pay raises to reduce the impact over the next couple of years.

@BG: Throughout the history of the 15-year mortgage, it has beaten the 30-year. You are paying the bank to take the risk of inflation. It’s a one-sided bet because you can get out of the deal by refinancing or paying off, but they cannot escape.

Put another way, people taking 15-year mortgages are taking on additional risk versus those with 30-year mortgages, for which they are rewarded by a lower interest rate – just as people with ARMs are rewarded with a lower interest rate for taking on the extra risk.

The mortgage rate doesn’t have to beat the inflation rate for the 30-year to beat the 15-year. The interest rate difference (15 versus 30-year) is a much bigger factor in the calculation.

The ONLY way to run the numbers is with the discounted cash flow (DCF), as JLP did.

Ignoring taxes and inflation, to simplify the discussion: The payment on a 30-year is lower than on a 15-year. If you invest this difference, as a rough rule of thumb, you will berak even over the 30 year period if your investment rate of return equals the 30-year rate PLUS double the rate difference between 15 and 30-year mortgages.

The way this works is that by the end of 15 years, you have a lump sum out of which you make the payments for the next 15 years. (It continues to earn the investment rate of return during that time.)

For example, if you borrow 100K at 5% for 30 years instead of at 4.5% for 15 years, and invest the difference in payment ($228 per month) at 6%, after 15 years, you will have a lump sum of $66300, and will still owe $67,800. $66,300 is enough to make payments for the next 15 years. Inflation, rising salary, the benefits of having a $66000 pseudo-emergency fund, etc. just make it even more attractive.

Here are a couple of examples:

30 year rate = 15 year rate = investment rate of return = 5%: Neutral

30-year = 5%, 15-year = 4.5%, IR = 5%: 15 beats 30 by $14,500.

30-year = 5%, 15-year = 4.5%, IR = 6%: 30 beats 15 by $6,700.

#18 Mark) I think you missed my point. You are assuming that someone can get a 5% mortgage mortgage, and immediately get a 6% return on something else. WHERE?

CDs are paying 2.75% for 5-years. That is nowhere near your 6% figure. The best ‘investment’ for the guy with the 30-year mortgage is to, *drum-roll please*, prepay the mortgage! Prepaying the mortgage ensures he is getting the best GUARANTEED rate of return.

If you don’t prepay the mortgage, and say you go for the next best thing (5-year CD): you are losing the difference: 5%-2.75% == 2.25% loss!

Now, the point I was trying to make earlier is that you are willing to take the 30-year, invest in something else (at a loss as I’ve described), and wait it out until the planets align and you start making money. How long will it take for inflation/CDs to turn around and make your strategy look like a winning one (in hindsight)?

Then you have to figure out how long it will take for you to recoup the losses that you suffered through at the beginning, JUST TO BREAK EVEN with the 15-year guy.

@BG: No I didn’t miss your point at all. I agree that right now inflation is low, and that for the next few years it will seem smart to prepay. The examples I gave were highly simplified, with fixed returns on investment. There are many scenarios in which 5 years of very low returns are more than compensated for later.

I also agree with you that it will be years before I know if I am right, and the easy answer is to prepay. In some ways I feel I am insuring myself against inflation. If there is none, all my “normal” investing works. If inflation does come along, I have protected myself.

I am also more fortunate than many people – my choice wasn’t just 15-year versus 30-year. I had the flexibility to pay cash, but I chose the 30-year mortgage.

As for where you can get 6%: A Vanguard mutual fund – VWEHX – high-yield corporate bonds, which are not for everyone, but work for me. Year-to-date return = 7.42%, current yield = 7.66%.

I think you have a pre-crash mindset. Debt only holds people back and creates massive problems for society. It’s time to stop trying to rationalize paying gobs of interest for 30 or 40 freaking years for the tax break that you can only get up front of the loan. It’s the monthly payment mentality that crushes people’s ability to become wealthy. The way you figure things, a perpetual mortgage would be the way to go. No way.

If people would just pay off their mortgages faster, they could pocket the P&I every month and become wealthy. We’re refinancing a 30 yr (6.25%) to a 15 yr (3.75%) fixed. P&I goes up about 10% and our overall payment with taxes and insurance goes down $25 after getting rid of PMI (FHA) and the escrow account that the mortgage company lovingly provided us! Our standard deduction is more than the interest we pay each year, so there is no tax advantage (a sham) in having a mortgage in our situation. Having a mortgage as a hedge to inflation is great if you HAVE to have a one, but the math gets better without the mortgage payment.

@ranch111: You made an excellent point: “Itโs the monthly payment mentality that crushes peopleโs ability to become wealthy.”

And it appears you made a good decision getting your interest rate down and eliminating PMI.

But I have to disagree with much of the rest – sorry!

If people would focus on the cost of money, long-term changes in the value of money, and opportunity costs they might make different decisions.

Eliminating the escrow account has limited value. You have simply replaced the monthly amount with two annual ones – insurance and property taxes. How much did they charge you to escape escrow? (It’s often a slightly higher interest rate.)

But it does have some value – the opportunity to time those property tax payments. If the due-date is December or January, you can do one in January and one in December every second year, which might help you bunch and itemize deductions.

My property taxes are so high (Texas) that I will always exceed the standard deduction.

We are ALWAYS pre-crash! The next one is right around the corner – maybe 10, 15 years from now. We just don’t know what will drive it yet.

If I could get a perpetual mortgage at a fixed rate under 5% I would definitely take it.

Your last point on hedging: A mortgage is one of the few (only?) options an everyday person has to hedge against inflation. The math has nothing to do with the mortgage payment.

I’m less interested in hedging against inflation and more interested in getting the highest return while I’m still employed/unretired. If that also happens to help on the inflation front, then it’s a bonus.

On my previous mortgage, I was 5 years in on a 4.85% 15-yr fixed. With the stock market in recovery last year, I wanted a mortgage that would lower my payment, yet still let me pay off the mortgage in 10 years (or less if I decide to retire earlier)… it was very tough to find a mortgage that met both criteria, but in Dec 2009 I found a 3.85% 10-yr ARM (fixed for 10-yrs, then it goes ARM)

Crunching the numbers in a spreadsheet, it was easy to show that with the new mortgage and investing the difference would allow me to pay off the mortgage 2 years sooner than the previous mortgage plan (e.g. payoff in 5 years instead of 7 years). My assumed return was 6.5% (one can get nearly 7% in municipal bond funds that I’m comfortable with, so my assumption is a fairly conservative one).

I love this article. Most people consider a mortgage to be “good” debt, which doesn’t need to be payed down as quickly as, say, credit card debt. Especially if you take your math into account, it could be a far more lucrative choice to invest that extra money rather than dump it into your mortgage. It appears that the biggest indicator is comparing the difference between (expected return rate – inflation) and (mortgage rate – inflation), although I could be wrong.

Regardless, it will be nice to be able to give solid evidence to people who are laser-focused on eliminating debt.

JLP,

I have created a model to duplicate your values in the first scenario above and have confirmed all your numbers except the Total Interest Net Inflation value of $36,850. When I discount each of the interest payments at 3% I get a value of $117,251.

Can you check your model or explain how you got your $36,850?

Curious,

I simply took the discounted total payments of $236,850 and subtracted the original balance of $200,000. Anything paid above $200,000 is interest.