Inflation

Inflation is damaging to many areas of the economy but there are certain situations where inflation is helpful. Many of the problems we are currently facing originated in the housing market. Without going into the details, we can summarize the 2 core issues. The cost of housing got too high and many borrowers are carrying more mortgage debt that they can comfortably afford.

Over the last few years there were many mortgages that were granted to people who couldn’t afford the payments. These are the sub-prime mortgages that are currently in trouble, with many of them destined to go into foreclosure. This represents 20% of the mortgages that were written over the last few years. I want to look at the other 80%.

Most of these homeowners have fixed rate mortgages in the 5 to 6.5% range. Soon the inflation rate could easily be higher than this range. But even if the rate of inflation only grows to the 5% range, these borrowers are paying the bank with dollars that have lesser value than the dollars they borrowed in the first place.

Currently, housing prices are depressed throughout the country. Some areas such as Florida have seen major drops in value while other like New York have seen minor drops. As the effects of inflation move through the economy, the price of everything goes up, including houses. The homeowner who presently, has little or no equity in his home, will begin to build up equity simply due to the influence of inflation.

The current price for housing is either at its lowest point or close to it. This means that today’s renters will see their rents increasing and will be motivated to purchase a home. Why? If for no other reason than to stabilize their cost of rent. Rents move up with inflation but a fixed rate mortgage payment doesn’t. This brings us back to why most people buy their home in the first place; to own a place where they can raise their family. It’s only over the last few years that a residence was viewed as an investment vehicle first and a place to live second.

The housing market is currently in a transition period. As we approached the peak in market prices last year the spread between paying rent and paying a mortgage increased to the point that owning became unaffordable without some form of exotic financing. The carry costs of ownership became too much for many owners and mortgage defaults began to pile up. This brought housing prices down and forced the disappearance of the exotic mortgage programs. Now we’re beginning to see the cost of renting going up in response to the increase in the number of renters.

Currently inflation is affecting everything except wages. We are now dealing with a higher cost of living (especially housing costs), tighter credit standards and a lack of confidence in the price of real estate. As time progresses we can expect to see housing prices stabilize (due to the increase in rent), credit guidelines becoming more realistic (a direct response to the stabilizing of housing prices), wages rising (since inflation will eventually impact labor costs) and consumer confidence increase (a natural response to all of the above).

Individually we won’t be better off financially when the economy comes out of this transition period but we will feel like we are. This is what a moderate level of inflation does for you. You make more money; it costs you more to live yet psychologically you fell wealthier. The more money flowing through your hands, the richer you feel.

There will be one group of people that will actually be richer, those homeowners who bought their homes with pre-inflation dollars and fixed rate mortgages. Inflation drives the cost of everything up except for the mortgage payment for these individuals. The buying power of every dollar earned by these people has dropped except for the dollars used to make the mortgage payment. Inflation will drive the cost of borrowing money up, it will drive up the yield paid on savings accounts but it has no adverse impact on the fixed rate mortgage payment.

These borrowers entered into a long-term contract with their lenders. This contract obligates the borrower to write the same monthly payment to the lender for as long as it takes to retire the loan. The contract obligates the lender to a specific interest rate; regardless of how much the lender’s cost of funds increases.

The inflation cloud does have a silver lining, but only for those who had the foresight not to buy more of a home than they needed and used a conservative fixed rate mortgage. If you’re a member of this group don’t get discouraged by all the bad economic news. It is only temporary and you will be in a stronger financial position when the economy emerges from this transition period.