Inflation is back in the news this year. While the U.S. inflation rate had remained low at about 2% since 2010, it has surged past 5% this year, pushing up prices and squeezing pocketbooks. Thankfully, there are a few ways to reduce the harmful impacts of inflation, and many Americans are already using one – homeownership. Here’s a look at what inflation is and how owning a home can offer some protection against it.
What is inflation?
Inflation is a general increase in prices and decrease in the value of money. When inflation occurs, products and services become more expensive on average. The more inflation there is, the more prices rise.
A monthly or annual “inflation rate” is used to measure inflation. The government calculates the inflation rate using the Consumer Price Index (CPI), which tracks the prices of over 80,000 products and services.
What are the effects of inflation?
As explained earlier, inflation causes prices to rise and the value of money to fall. This means that wealth that is kept in property, such as a home, is often better protected from inflation, while wealth that is kept in cash, such as a bank account balance or paper bills, typically loses value to inflation. This is because property prices often go up with inflation, while cash buys less as prices rise.
For example, if the annual inflation rate is 5%, a $200,000 home affected at that rate would increase in price by an extra $10,000 ($200,000 x 0.05) a year. Conversely, a $200,000 bank account balance would fall in value by about $10,000 a year since the cash would no longer buy as much due to increasing prices. While some cash accounts do pay interest, it’s often not enough to keep up with inflation.
How does homeownership guard against inflation?
There are three important ways in which owning a home can provide protection against inflation.
- Home prices usually rise with inflation
One of the rising prices no one complains about is the price of the home they own. Home prices typically increase with inflation, and when you own your home, that means your investment is likely to be protected from inflation or even benefit from it. If inflation is a rising tide, then your home could be thought of as a boat that rises with it.
- Rent typically increases with inflation
The alternative to owning a home is renting, and rents usually go up with inflation. While some of the costs of homeownership increase with inflation too, if you have a fixed-rate mortgage, your monthly mortgage payment (principal and interest) will never increase! That means the higher rents rise and the longer you stay in your home, the bigger your savings over renting are likely to be.
- Fixed mortgage payments devalue with inflation
Thanks to inflation, if you have a fixed mortgage payment, the value of the money you pay your lender decreases as long as there’s inflation. For example, assume you earn $50,000 a year at the start of a 30-year mortgage, the inflation rate is 3% during every year of your loan and the “real value” of your income never increases (you only received a 3% cost-of-living adjustment every year). After 30 years, your income would be $122,855, but your mortgage payment (principal and interest) would remain the same!
Make no mistake, this is a simplification of a fairly complex topic. There are additional ways to reduce the effects of inflation, such as certain investment strategies, and inflation alone is not a reason for someone to rush into homeownership before they’re ready. But as part of a solid financial plan, it’s easy to see why inflation protection is one of the many benefits of homeownership.
For a free mortgage consultation to learn about your options for buying or refinancing a home, get in touch today.