Tuesday, August 28, 2007

Inflation can be your friend.

JLP at AllFinancialMatters has a very interesting post on the impact that inflation has on the true cost of a mortgage. He argues that, because of inflation, the dollars used to make a mortgage payment ten years from now will be worth far less than the dollars used to make a payment today. Therefore, assuming that the amount of the mortgage payment remains constant over those ten years, the cost of the mortgage essentially goes down over time.

This is a great observation, and it has really got me thinking. I was curious what the impact would be on our own mortgage, and found that adjusting for a 3% inflation rate takes our actual cost of borrowing (total payments minus starting principal) from $190K down to $54K. That's a huge difference!

As I played around with these numbers, it occurred to me that this principle can also be used to accelerate a debt paydown. If we were to increase our mortgage payments by 3% each year, we would shorten the life of our mortgage by six years, while further lowering the adjusted cost of borrowing to $44K. Obviously, the challenge is in actually finding that extra 3% each year, but by really making a commitment and developing a sufficiently lean budget, this may very well be manageable.

I'll be looking very seriously at implementing something like this in the new year. I'll let you know how it goes.

3 comments:

SavingDiva said...

I read that post too...he's pretty persuasive about the actual difference in mortgages...

Canadian Dream said...

Interesting idea, but there is a small hole in it all.

Do you really think inflation is running at 3%? For the last 12 years in Canada we rarely broke 2.5% and then there is research to suggest the CPI is overstating inflation by 0.5%. In the US it is worse and the bias is around 1.1%.

Just some thoughts,
Tim

Loonies And Sense said...

True, this relies heavily on the assumed rate of inflation.

However, even at 2%, taking inflation into account cuts the cost of borrowing by as much as half. The point is not so much the exact number, but the fact that "I'm buying my house again with the interest" is usually over-stated.

Looking at the flip-side, where you increase your mortgage payments by your own inflation factor, this will always significantly shorten the life of the loan, and bring down the cost of borrowing.