With inflation stubbornly hovering at a rate of 8 percent throughout most of 2022, its general effect on the economy has been less than desirable – rising interest rates, drops in the stock market, and higher prices all around for consumers.
But could there be some sliver of good to come from inflation? At least one real estate enthusiast believes so. In this post, we’ll introduce you to the concept of inflation-induced debt destruction and how it can be used to benefit your net worth.
What is Inflation-Induced Debt Destruction?
Inflation-induced debt destruction is when the value of the money you owe becomes eroded by inflation. As the prices of all goods and services naturally rise, the purchasing power of your dollars weakens. While this means you can’t buy as much, it also means the value of any long-term debt you owe is also decreasing. From the perspective of the borrower who’s making fixed monthly payments, this could actually be a good thing.
The concept of inflation-induced debt destruction has been credited to real estate guru Jason Hartman. Though he encourages this logic as a motivator for acquiring investment properties, the same basic concept can also be applied to regular homeowners. Let’s go through a simple example.
How Does Inflation-Induced Debt Destruction Work?
Suppose you buy a home with a fixed rate 30-year mortgage and the monthly payment is $1,500. For the life of the loan, if it remains unaltered, we know that the principal and interest payments will always be $1,500.
Next, suppose inflation for the year was 3 percent. In theory, the price of everything around you rose by 3 percent – food, energy bills, gas, etc. Perhaps your employer also gave you a 3 percent increase to keep up with inflation.
Overall, all your expenses now cost more. But your mortgage payment is still only $1,500. It didn’t change, and it will continue to stay the same in what’s called “nominal” dollars.
However, when we look at this mortgage payment through the lens of inflation, that $1,500 is actually now worth 3 percent less. The lender receiving that payment can now only buy $1,455 ($1,500 minus $45) of goods and services in today’s money because of inflation. This is what’s called “real” dollars.
Let’s continue this pattern for the next 15 to 20 years. Assuming inflation continues to rise at an average rate between 3 and 4 percent per year, eventually, the price of everything will be about twice what it is today. Even the market resale of your house may now be double what you originally paid!
Additionally, your wages may have continued to keep up with inflation, or you might have gotten a new job at today’s market rates. Either way, your mortgage is still the same $1,500 every month. But in real dollars, it probably feels like half of what it used to be compared to all your other expenses (or $750 in today’s dollars). In other words, inflation has destroyed half of the debt you owe.
Leveraging Inflation for More Equity
As a real estate investor, Hartman believes the greatest return from inflation-induced debt destruction is with rental properties. Just like your personal home, rental properties can be bought with fixed-rate mortgages that will slowly erode in real dollars each year as inflation increases. However, unlike your house, the owners of rental properties will typically use the rent payments that they receive from their tenants to pay back the mortgage lender.
As an added bonus, inflation causes the rent charged by the owners to go up. They might pay you $1,000 this year, $1,100 in two to three years, and theoretically $2,000 in 15 to 20 years. Yet, the entire time, what you owe to the mortgage lender will remain static. That means more monthly profit for you as time goes on.
Finally, when you go to sell that rental property, you can collect on all the equity your tenants helped you to build. But you’ll also receive any equity that inflation created due to the market price of the property increasing. Again, that’s more money back in your pocket.
Debt is Still Debt
Looking at inflation through the eyes of debt destruction is an interesting way to spin the topic. But no matter how you choose to see it, debt is still debt. And if having debt is something that makes you uncomfortable or you’d just simply rather not have it, then it’s important to prioritize paying it off.
In the case of your personal property, while it may seem like stretching your payments out as long as possible might be the right way to go, don’t forget about interest. Even though that mortgage payment remains static, it has interest baked in that you won’t naturally recover with your equity.
A simple online mortgage calculator will reveal that the borrowers of 15-year loans pay substantially less interest over the life of the loan than those with 30-year mortgages – sometimes as much as hundreds of thousands of dollars. Regardless of the effects of inflation, handing over less money in interest to the bank can be a very powerful motivator to pay your mortgage off as quickly as possible.
Finally, also consider what eliminating a house payment can do for your retirement plan. For instance, someone who pays off their $1,500 per month mortgage before they retire will need approximately $450,000 less in their nest egg than someone who hasn’t.
When it comes to your household finances, it’s important to look at them from multiple perspectives. Take a hard look at your budget and look for any opportunity you can to make improvements. Consider the pros and cons of each of these strategies, and then pick the side that you believe will suit you and your finances the best.
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