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How Does Inflation Affect a Mortgage?
Karen writes in:
My brother has argued with me that I shouldn’t make any extra payments on our mortgage because we’re losing money over the long term by making early payments. He says that with inflation at 3% and our money able to earn 1% at minimum in a savings account and more if we do other things, we’re losing money by making early payments on our 3.75% mortgage. What do you think?
From a purely financial perspective, your brother does have a good point. However, your brother’s case has a bunch of implied assumptions that don’t necessarily apply to your situation.
Let’s look at the math of the situation
Let’s say that you get a raise at work that equals the rate of inflation. Since your mortgage payment stays the same (assuming it’s a fixed rate mortgage), that means that your mortgage payment will take up a smaller and smaller percentage of your income over time. With the percentages expressed by your brother, your mortgage payment will take up only about a third as much of your income by percentage during the last year of your mortgage compared to the first year of your mortgage.
Want real numbers? Let’s say your monthly mortgage payment is $1,000 and you bring home $30,000 a year. Right now, you’re paying $12,000 a year in mortgage payments, which is 40% of your take-home pay. Each year, though, you’re getting a 3% raise. After ten years, you’re making a little over $40,000 a year, dropping your mortgage payments down to only 30% of your take-home pay. After twenty years, you’re bringing home around $54,000 per year, dropping your mortgage payments down to about 22% of your take-home pay. During the last year of your mortgage, you’re bringing home $72,800 per year, making your mortgage payments around 16% of your take-home pay.
The argument against early payments is that at the point where mortgage payments make up 40% of your take-home pay, it doesn’t make sense to pay even more just so that you eliminate payments at a later date where the payment is only taking up 16% of your take-home pay.
Do mortgages adjust for inflation? Or, perhaps you’re more concerned with the more pertinent question — do mortgages increase with inflation? It depends on the type of mortgage loan. Those with fixed-rate mortgages won’t be negatively impacted by higher inflation as the interest rates are locked in, as the name implies. Fixed-rate mortgage holders may even benefit from increased inflation since they are paying back money at a much lower value than it was borrowed at. Variable-rate mortgages, on the other hand, have interest rates that increase or decrease with economic fluctuations, which leaves borrowers with variable interest rates and payments.
That’s a pretty powerful argument. It forgets a few things, though.
First, it assumes your income steadily increases at the rate of inflation or better. The truth of the matter is that wage growth isn’t keeping up with inflation in most industries and, in many industries, wages are actually seeing negative growth.
Most Americans can’t rely on the idea that their wages will routinely go up. That’s just not reality for the majority of people out there. Yes, there are people who are smart and work hard and have an entrepreneurial bent and a big pile of transferable skills who can keep increasing their wages, but that’s not something you can plan on unless you’re exhibiting confidence bordering on arrogance.
Second, it assumes that you can earn a sizeable steady return from a small investment. If you have $500,000 sitting in the bank, you can probably find some ways to invest it that can earn a nice return on that money, better than the 4% or so return you might get from other things. It’s much harder to do that with $1,000 in the bank.
Most Americans do not have the capital on hand to buy a rental property. Many Americans struggle to have an emergency fund. With an extra mortgage payment, a person can get a steady 3.75% return (in the mortgage example above) from every single dollar they pay ahead on their mortgage.
Third, it assumes an inflation rate. The Consumer Price Index, which is likely the best tool for estimating inflation, has only touched 3% once in the last several years and is usually around 1.5 to 2%. Some people debate whether CPI is a good measure of inflation and some argue for other rates, but CPI is a pretty solid benchmark for inflation.
Inflation does vary over time, but we’re currently in a period of very low inflation. Most inflation-based arguments rely on an inflation rate of at least 3% for people to make financial moves based on the inflation rate.
Finally, it assumes inflexibility. If you’re in a position where inflation is at 5% and savings accounts are paying a 6% return, it makes a lot of sense to put money into a savings account and make minimum payments on a 3.75% mortgage. On the other hand, when we’re in the position we’re at now, with savings accounts paying 1% and inflation somewhere around 2%, you’re going to want different solutions. Just because you choose to make early payments now doesn’t mean you can’t choose to do something differently later on.
Ideally, the longer you’re in the workforce, the more raises you’re likely to receive at the rate of inflation (or better) — and thus the less percentage of your paycheck your mortgage will take up.
However, don’t assume that will be the case, as annual raises are not reality for most people. In many industries, wage increases aren’t keeping up with inflation and many people don’t have the means to make a sizable investment to get a large return. While inflation rates do fluctuate, they rarely reach 3%. Rates are sitting at 1.4% as of September 2020.