While we are discussing inflation, I wish I would have better understood the real impact of inflation on interest rates and what that means for the actual cost of money. Let’s discuss an interest rate of 3.4% and an inflation rate of 6.8% (according to BLS.gov/cpi for December 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 – meaning that more dollars are chasing the same goods. Therefore, the visual prices move up in what we call inflation. For example, 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. The longer the time and dollars printed and put into the supply, the less the dollar is worth and the more required to purchase the same goods or services.
If you are interested in how your purchasing power is diminishing, then you can go to https://www.bls.gov/data/inflation_calculator.htm and check out the BLS CPI inflation calculator for some fun. You can see in the illustration from the government’s BLS calculator that $1M in the year 2000 would require over $1.7M in 2023 to purchase the same goods and services as $1M in 2000. In the second example, you can see that $862,289 in 2020 would require $1M in 2023 to purchase the same goods. This means that in 3 years from 2020 to 2023, everyone lost $137,711 of purchasing power or $45,903 a year over those 3 years!
How does this apply to debt or mortgage payments? In essence, 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% (12/2021 – mortgage rate 3.4% and CPI 6.8%)
[(1+.034)/(1+.068)-1] = -3.18% (real rate based on inflation)
Now consider: If the inflation rate from December 2020 of 1.4% is used and the same note rate of 3.4%, then the real interest rate would be 1.97% vs the -3.18% for December 2021.
[(1+7.37%)/(1+3.24%)-1] = 4.0% (11/2023 – mortgage rate 7.37% and CPI 3.24%)
[(1+.0737)/(1+.0324)-1] = 4.0% (real rate based on inflation)
https://www.mortgagenewsdaily.com/markets/mortgage-rates-11162023 https://ycharts.com/indicators/us_inflation_rate
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 books just to scratch the surface, not to mention topics like stagflation, deflation, money cycles, and the rise and fall of global reserve currencies.
