# How inflation affects real interest rates and investment returns

Let’s discuss an interest rate of 3.4% and an inflation rate of 6.8% (according to BLS.gov/cpi for December of 2021) and look at the outcome. Inflation eats away at the future purchasing power of a dollar. In other words, it buys less because it has been devalued. The same \$1M today, will not buy \$1M of goods next year, but only say \$932K worth of goods. Because of the 6.8% inflation rate you will need \$1.068M to purchase the same assets or goods next year.

Regarding debt/mortgage payments: you are paying back your fixed rate loan in the future with cheaper and cheaper money. Because you locked in your debt payments today with today’s purchasing power, the longer you hold the note and the more the dollar is devalued the greater the hedge or delta against inflation. Meaning that you will have more to spend in the future as you locked in debt at x value today, allowing rents to keep pace with inflation while your payments are anchored at a previous years buying power.

To show the advantage of locking in today’s purchasing power via a fixed rate mortgage or debt mathematically, use the following formula to calculate

Real Interest Rate = [(1 + Nominal Interest Rate) / (1 + Inflation Rate)] – 1 or

[(1+3.4)/(1+6.8)-1] = -3.18%

Now consider: If the inflation rate from December of 2020 of 1.4% is used and same note rate of 3.4%, then the real interest rate would be 1.97% vs the -3.18% for December of 2021. Hopefully you can see how inflation works in your favor as an investor with fixed debt on an income producing asset. In addition, you can begin to understand why governments attempt to create inflation as a way to “inflate their way out of debt.” That topic however, would take a whole series of blogs just to scratch the surface, not to mention topics like stagflation and deflation.

For more information on finance and the economy: The Creature from Jekyll Island: A Second Look at the Federal Reserve