Readers Question: I understand why, generally, low inflation is considered to be a good thing and why high inflation is bad particularly if you have savings whose value in real terms then diminishes faster.
What I do not understand is why inflation is not in fact a good thing for those of us in their late 30s, saddled with a huge mortgage, two kids, and no savings to speak of. Surely once I have bought a house for £x, what I really want is for the cost of it (which is of course fixed when I hand over the purchase price – this is nothing to do with what happens to the VALUE of the property in future since that only has an impact if I ever sell) in real terms to drop as quickly as possible, so that the cost of borrowing to fund it becomes a smaller part of my income as quickly as possible?
To give an extreme example, my parents bought their first house in 1964. They paid about £1500. This felt like a fortune at the time, but they could probably get an overdraft to refinance it now, if they had only ever had an interest only mortgage! And the interest payments themselves, though a struggle in 1964, would be a quite trivial amount relative to their income now.
So surely if inflation hits 10% (I know that is unlikely, but let’s just say, for the sake of argument), and since I do not propose to move again, then the cost of my house (which remains thus static at what I paid for it) IN REAL TERMS will drop faster so that, assuming my salary at least keeps up with inflation, I’m going to be better off than if the £300,000 I paid still “feels” like £300,000 in 10 years’ time?
Thanks for the question. You raise a good point. Inflation is generally considered to be a damaging thing for the economy. There are many costs of inflation such as uncertainty, declining competitiveness, menu costs. For full explanation see: Costs of inflation. However, although inflation is generally bad, there are some people who will benefit from inflation (as long as nominal wages rise faster than inflation)
If you keep money under your bed, inflation will reduce the value of your savings. But, if you borrow a fixed amount, inflation makes it much easier to pay back (assuming wages keep pace with inflation, which generally they do in OECD economies)
When people are considering whether to buy or rent, they often forget the importance of inflation. They look at the cost of mortgage payments and focus on how expensive they are. But, these mortgage payments historically, decline in real terms over the course of the mortgage.
When I took out my mortgage in 2004, I paid £800 a month. Nearly 45% of my post tax income. But, I saw it as an investment. If my salary increases by 4% a year (not unreasonable given past trends), my mortgage payments will decline as a % of income. (It is now 40% of disposable income. In 30 years time, when I am still paying my mortgage, I expect £800 to be a relatively small % of income. Just like your example.
If I continue to rent, the cost of renting is likely to rise by at least inflation (In Oxford, rent has increased faster than inflation). Therefore in 30 years time, I’m sure monthly rent, will be much more the cost of my mortgage.
Interest Rates Inflation and Mortgages
The only problem with rising inflation is that as inflation rises, interest rates usually rise. For example, in 1991 inflation and interest rates reached double figures, making the cost of mortgage payments rise temporarily. This led to a record rise in repossessions. If inflation was to rise to 10% like in your example, I would expect interest rates to increase to 12%, this could double your mortgage interest payments. My £800 a month would increase; I may even be unable to pay it. But, you are right, the £300,000 mortgage would become worth less.
However, if you took out a fixed rate mortgage you could insure against this spike in interest rates.
Nevertheless, assuming fairly constant average inflation and interest rates. Mortgages definitely become easier to pay back over time. Inflation and real wage growth make it much easier to pay back.
The best thing would be for inflation to stay at 3%, interest rates to stay at 5% and nominal wage inflation of 5% (making real wage growth of 2%) This would lead to a gradual reduction in the real value of your mortgage debt, without having spikes in the cost of mortgage payments.