How a home mortgage can help you build real wealth. Plus what factors to weigh if you are considering paying off your mortgage.
In this episode, you’ll learn:
- What is money illusion.
- What causes housing booms and home price bubbles.
- How to talk about a book you haven’t read.
- How having a mortgage can help you build real wealth.
- What causes inflation.
- What causes the money supply to increase.
- How having a mortgage can act as an inflation hedge.
- Should you pay off your mortgage.
Why You Shouldn’t Pay Off Your Mortgage
In my previous essay, I discussed how home prices after adjusting for inflation and upkeep decline over time. Homes depreciate like cars. They get old and go out of style.
Falling home prices are less noticeable because the useful life of a house is much longer than a vehicle’s useful life, and in a normal environment homes that are properly maintained keep pace with inflation.
Home prices can deviate from their long-term trend due to volatile land prices and periods of exuberance and fear that can lead to housing booms and busts like we saw in the past ten years in the United States.
Factors that contribute to boom cycles in houses include low interest rates, low inflation, loose lending standards, low unemployment, rising incomes and more than anything a belief by potential buyers that home prices will continue to increase.
Eventually, though, all housing bubbles burst.
If houses show little if any real appreciation after adjusting for inflation and maintenance, and they are prone to booms and busts, why would anyone want to own a home?
Reasons To Own A Home
First, we have to live somewhere so our choice is either to rent or buy. Some people buy homes for lifestyle reasons because they want to live in a certain area for the schools or for other amenities, and there is an inadequate supply of rental housing in the preferred area.
Additionally, there are times when owning a home despite its property tax and maintenance burdens is cheaper than renting as it was in many U.S. cities in the last several years after house prices plummeted.
Finally, when a home is purchased at an attractive price with a low interest fixed rate mortgage it can be an effective tool for building wealth even if the home only appreciates by the rate of inflation. In fact, one can build more wealth by purchasing a home with a fixed rate mortgage than by paying cash for the house.
Why is that?
Inflation reduces the real balance on your mortgage at the same time it increases the nominal price of your house. That combination can increase your real wealth.
Let me explain.
What Causes Inflation
Recall that inflation is the general increase in prices due to an increase in the money supply. When the supply of money flowing through an economy increases at a faster pace than the amount of new goods and services being produced than prices increase.
The primary reason the money supply increases is because households and businesses borrow money from banks.
When a bank lends to someone, the bank receives an IOU from the borrower and sets up a deposit at the bank in the amount of the loan. The borrower can then access the borrowed funds.
The loan allows the borrower to shift future consumption into the present because the borrower gets to purchase what they want today while forgoing some future purchases due to the need to pay back the loan.
At the same time, our modern banking system is based on digital currency so when a bank makes a loan and places a deposit in the borrower’s account the bank simply changes the digits in the account. New money is created out of thin air.
The combination of new money being created by banks and borrowers shifting future consumption into the present leads to inflation.
Inflation means a dollar in the future will purchase less than it does today. When you sell your home in the future the buyer will need to come up with more money than they would today not because the house is more valuable in real terms but due to inflation.
Inflation also means you will be paid more money today for your employment even if you are producing the same amount of output or adding the same amount of value as you are today.
Inflation’s Impact On Debt
There is one thing, though, that isn’t going up in value with the overall inflation trend. Your debts.
Banks don’t increase your loan balances each year by the rate of inflation. Your monthly payment stays the same if you have a fixed rate mortgage even as you get cost-of-living salary increases. That means you have more money to pay down debts.
If your debts are not being increased by the rate of inflation that means that on an inflation-adjusted basis (i.e. on a real basis) they are going down even if you don’t make any payments.
Today you can get a 15 year fixed rate mortgage at 3.2%. If the annualized rate of inflation over the next 15 years is greater than 3.2%, the total value in today’s dollar of principle and interest payments you make on the loan plus your down payment will be less than original cost of the house.