Does inflation (deflation) benefits the borrower (lender)?

February 19th, 2008

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Price inflation is on the uptrend in Australia. As a result, interest rates are going up and the cost of servicing a mortgage loan increases as well. But some people claim that price inflation is good news for the borrower. The logic behind such a claim is that the real value of the debt decreases due to price inflation. Conversely, deflation benefits the lender because the real value of the loan increases due to price deflation.

Is this always true? Of course not!

In what circumstances will price inflation benefit the borrower? When will it be detrimental? To make life easier for you, we will provide you with a highly simplified rule-of-thumb formula that will help you to understand whether price inflation will harm or benefit you as a borrower:

Debt servicing burden = (Debt payment rate – Growth in wage) + Price inflation rate

As you can see, price inflation alone does not reduce your debt burden. Your wage has to grow along with price inflation. But that is assuming that the debt payment rate (e.g. mortgage rate) does not increase.

The worst-case scenario is when your debt payment rate increase along with price inflation, while your wage remains stagnant-in such a situation, you find your mortgage payment and life expenses increasing while your wage remains constant. For Australia, this is the current situation. Mortgage and interest rates are rising, price inflation is increasing, but wages have yet to catch up. No wonder borrowers are finding life harder!

  • Pete

    It is uncanny how this site can answer questions I ask myself, before I could ever get to researching them properly.
    And the arguments are so well thought out and articulated, the articles are brilliant.

    Thank you!

    (sorry if you find I thank you too often, I just think it is deserved :))

    – Pete

  • Pete

    It is uncanny how this site can answer questions I ask myself, before I could ever get to researching them properly.
    And the arguments are so well thought out and articulated, the articles are brilliant.

    Thank you!

    (sorry if you find I thank you too often, I just think it is deserved :))

    – Pete

  • No worries Pete! We are glad we can be of help to you. Your comments are greatly appreciated.

  • No worries Pete! We are glad we can be of help to you. Your comments are greatly appreciated.

  • ckb

    I am not so sure that the answer is so clear-cut. For it might be true that one is getting progressively worse off in terms of immediate cash flow, and yet profit from price inflation at the same time. Let us assume, for example, that you purchase two properties @ 250K each on borrowed money, and that even though rental and your wages growth do not quite keep up with interest rate hikes over a 7 – 10 year period, over which inflation doubles the nominal value of your two properties, you manage the repayments. At this point you can simply sell off one of these properties and fully own the other one. Lo and behold, inflation and your tenants, and the relatively little extra that you chipped in from your own wages along the way, have delivered to you a solid, income producing investment.

    This is pretty close to how property investment seems to work in the long term, and inflation, it seems to me, is doing a good chunk of the work. And, if that is more or less right, then maybe you can, after all, borrow yourself to riches.

  • ckb

    I am not so sure that the answer is so clear-cut. For it might be true that one is getting progressively worse off in terms of immediate cash flow, and yet profit from price inflation at the same time. Let us assume, for example, that you purchase two properties @ 250K each on borrowed money, and that even though rental and your wages growth do not quite keep up with interest rate hikes over a 7 – 10 year period, over which inflation doubles the nominal value of your two properties, you manage the repayments. At this point you can simply sell off one of these properties and fully own the other one. Lo and behold, inflation and your tenants, and the relatively little extra that you chipped in from your own wages along the way, have delivered to you a solid, income producing investment.

    This is pretty close to how property investment seems to work in the long term, and inflation, it seems to me, is doing a good chunk of the work. And, if that is more or less right, then maybe you can, after all, borrow yourself to riches.

  • Hi ckb!

    … over which inflation doubles the nominal value of your two properties

    Here’s the catch- for this to work, the property price have to grow faster than price inflation over the long term. In other words, the real (as oppose to nominal) value have to rise over the long term.

    If the real value of property appreciates (as in the last 10 years in Australia), the implication is that the debt servicing burden of the economy as a whole will increase. But as debt servicing burden increases, it will impose a drag on the economy to sustain further increase in the real value of property. It will increase up to a point when the burden is too great, which implies that the real value of property can no longer increase. In fact, it may even decrease as history shows. Australia is somewhere at that point now.

    Borrowing for property is a long term committment. For it to work over the long term, its price have to increase faster than price inflation over the long term. The mistake is to project what happened in the past 10 years into the indefinite future.

    But on the other hand, if one is quick to flip properties the way stocks are flipped, then it is possible to profit. But that would be closer to speculation than investing.

  • Hi ckb!

    … over which inflation doubles the nominal value of your two properties

    Here’s the catch- for this to work, the property price have to grow faster than price inflation over the long term. In other words, the real (as oppose to nominal) value have to rise over the long term.

    If the real value of property appreciates (as in the last 10 years in Australia), the implication is that the debt servicing burden of the economy as a whole will increase. But as debt servicing burden increases, it will impose a drag on the economy to sustain further increase in the real value of property. It will increase up to a point when the burden is too great, which implies that the real value of property can no longer increase. In fact, it may even decrease as history shows. Australia is somewhere at that point now.

    Borrowing for property is a long term committment. For it to work over the long term, its price have to increase faster than price inflation over the long term. The mistake is to project what happened in the past 10 years into the indefinite future.

    But on the other hand, if one is quick to flip properties the way stocks are flipped, then it is possible to profit. But that would be closer to speculation than investing.

  • ckb

    Yes, although it does become a little tricky to keep in mind as to what is what – in part because of the conceptual ambiguities that are often involved when we hear people talk about inflation. I had in mind the Austrian concept of inflation, and namely the excess supply of money in the economy over and above GDP, or the supply of gold, or some such measure. Then of course there is the doctored figures we are being fed with about the annual inflation rate (currently just over 4%, we are told), which at the least can be misleading. Is this what you refer to as price inflation?

    Anyhow, in the example I tried to give, I assumed that the “value” of the properties doubled simply because the annual money supply artificially pushed up real estate prices. I don’t quite see that for the example to work the increase in value should have to be “real” in some deeper sense. What does this mean anyway. To my mind, increases in property prices are due, by and large, to the very same causes as increases in consumer product prices, and namely, excess supply of money. Note that I did not assume in the example that the properties in question produced increased yields over the years, which would serve as a basis for a fundamental increase in their value, attributable over and above the excess increase in money supply.

    To summarise, if we assume that the doubling in price is due exclusively to inflation (in the Austrian sense), and also that one’s rental income and wages stay constant (they do not increase), it would seem quite possible to come out ahead over time, because inflation, and nothing but inflation, will reduce the weight of the initial debt burden by half – which is what Realtors have been said to be claiming about taking on debt to invest in an inflationary environment.

    Have I missed something?

  • ckb

    Yes, although it does become a little tricky to keep in mind as to what is what – in part because of the conceptual ambiguities that are often involved when we hear people talk about inflation. I had in mind the Austrian concept of inflation, and namely the excess supply of money in the economy over and above GDP, or the supply of gold, or some such measure. Then of course there is the doctored figures we are being fed with about the annual inflation rate (currently just over 4%, we are told), which at the least can be misleading. Is this what you refer to as price inflation?

    Anyhow, in the example I tried to give, I assumed that the “value” of the properties doubled simply because the annual money supply artificially pushed up real estate prices. I don’t quite see that for the example to work the increase in value should have to be “real” in some deeper sense. What does this mean anyway. To my mind, increases in property prices are due, by and large, to the very same causes as increases in consumer product prices, and namely, excess supply of money. Note that I did not assume in the example that the properties in question produced increased yields over the years, which would serve as a basis for a fundamental increase in their value, attributable over and above the excess increase in money supply.

    To summarise, if we assume that the doubling in price is due exclusively to inflation (in the Austrian sense), and also that one’s rental income and wages stay constant (they do not increase), it would seem quite possible to come out ahead over time, because inflation, and nothing but inflation, will reduce the weight of the initial debt burden by half – which is what Realtors have been said to be claiming about taking on debt to invest in an inflationary environment.

    Have I missed something?

  • ckb

    “Australia is somewhere at that point now.”

    Yes, well, this is a very interesting subject, and I would like to know about it more. It seems that there is a significant difference between Aussie and US borrowers where property investment/home ownership is concerned, and namely that, unlike here, in the US people can simply walk away from their debts if they find themselves upside down with their mortgage.

    I am wondering as to how much more pain Aussie borrowers will be willing to go through because of this by comparison, and whether our market has managed to keep going up and up in spite of rising interest rates.

    Another one is whether the said increases in rents, and therefore yields where investment properties are concerned, some of them phenomenal, and more are predicted to come, are not contraindicating predictions of a collapse in prices. If anything, increasing yields should help push prices still higher.

    And finally, closely connected with the increasing yields, is the fact that there are not enough places to rent where this is so. Indeed, this is said to be the reason why rents are going up. And if we have a shortage of houses, because even as we speak, we are not exactly going through a building boom, are we?, would that not mean also that prices should be heading still higher, rather than lower?

    And finally finally, lol, there is now an increasing trend of more and more investors purchasing properties through their SMSFs. And not only purchasing outright, but also with borrowed money. Since people cannot touch their super until they reach retirement age, many have been saving up enough to be able to afford a decent deposit for a property and borrow the rest.
    This is definitely an increasing trend, and I have a sneaking feeling that, especially with rents going up and yields being better and better, this will give yet another impetus for property prices to keep going up for a while yet, rather than collapsing in a hurry.

    So, given all these forces, in spite of property prices hitting ever new records relative to the median wage, we are unlikely to see a property crash until a collapse in employment or a glut of properties starts hitting the market. Such a glut could come, of course, from a building boom, which at the moment seems unlikely, or from still higher interest rates, which perhaps is more likely. Any thoughts on these?

  • ckb

    “Australia is somewhere at that point now.”

    Yes, well, this is a very interesting subject, and I would like to know about it more. It seems that there is a significant difference between Aussie and US borrowers where property investment/home ownership is concerned, and namely that, unlike here, in the US people can simply walk away from their debts if they find themselves upside down with their mortgage.

    I am wondering as to how much more pain Aussie borrowers will be willing to go through because of this by comparison, and whether our market has managed to keep going up and up in spite of rising interest rates.

    Another one is whether the said increases in rents, and therefore yields where investment properties are concerned, some of them phenomenal, and more are predicted to come, are not contraindicating predictions of a collapse in prices. If anything, increasing yields should help push prices still higher.

    And finally, closely connected with the increasing yields, is the fact that there are not enough places to rent where this is so. Indeed, this is said to be the reason why rents are going up. And if we have a shortage of houses, because even as we speak, we are not exactly going through a building boom, are we?, would that not mean also that prices should be heading still higher, rather than lower?

    And finally finally, lol, there is now an increasing trend of more and more investors purchasing properties through their SMSFs. And not only purchasing outright, but also with borrowed money. Since people cannot touch their super until they reach retirement age, many have been saving up enough to be able to afford a decent deposit for a property and borrow the rest.
    This is definitely an increasing trend, and I have a sneaking feeling that, especially with rents going up and yields being better and better, this will give yet another impetus for property prices to keep going up for a while yet, rather than collapsing in a hurry.

    So, given all these forces, in spite of property prices hitting ever new records relative to the median wage, we are unlikely to see a property crash until a collapse in employment or a glut of properties starts hitting the market. Such a glut could come, of course, from a building boom, which at the moment seems unlikely, or from still higher interest rates, which perhaps is more likely. Any thoughts on these?

  • Hi ckb!

    … conceptual ambiguities that are often involved when we hear people talk about inflation.

    How about we stick to monetary inflation as in the Austrian School definition and price inflation as in the mainstream definition?

    To my mind, increases in property prices are due, by and large, to the very same causes as increases in consumer product prices, and namely, excess supply of money.

    One thing to note: monetary inflation will affect the prices of different things with different time-frames to different extent. In Zimbabwe, it is consumer prices (and stock prices as well) that bore the brunt of monetary inflation. There’s no guarantee that it will affect the prices of property most favourably to property speculators. A very good example will be the US right now- they are experiencing property price deflation and consumer price inflation simultaneously.

    Realtors would like us to believe that property are reliable hedge against price inflation, but in reality, they’re don’t always work out favourably. It is possible for consumer prices to rise much faster than property prices. When that happens, property speculators are stuffed.

    … it would seem quite possible to come out ahead over time

    Yes, the keyword is “possible.” That means it is not always true.

    … is the fact that there are not enough places to rent where this is so

    We would challenge the idea of housing ‘shortage’ that is often announced by the mainstream media propaganda. More details at Myths on the Australian housing/rental crisis & its implications. In fact, if there truly is an overall shortage of housing in Australia, why is it that vacant houses increases much faster than population growth from 2001 to 2006? The problem with Australia is not one of outright shortage. Rather, it is a mismatch between supply and demand. For example, some areas of Sydney has over-supply of housing and some areas, there are over-demand.

    And if we have a shortage of houses, because even as we speak, we are not exactly going through a building boom, are we?, would that not mean also that prices should be heading still higher, rather than lower?

    We have an answer for that at Another faulty analysis: BIS Shrapnel on house prices. When we look at hosue prices, we cannot apply simple demand/supply on them as if they are commodities. This is because most house purchase are finance with debt. It is debt that complicates the equation.

    … a glut of properties starts hitting the market.

    Do you know that there are already a glut of properties in some parts of Sydney (e.g. Western Sydney)? In these areas, it is possible to see entire block of brand new apartments unsold. There are a lot of new developments in of brand new housing, and no demand, mainly because of woefully inadequate infrastructure.

    The mainstream media will not tell you that, probably because they are bought off by realtors.

  • Hi ckb!

    … conceptual ambiguities that are often involved when we hear people talk about inflation.

    How about we stick to monetary inflation as in the Austrian School definition and price inflation as in the mainstream definition?

    To my mind, increases in property prices are due, by and large, to the very same causes as increases in consumer product prices, and namely, excess supply of money.

    One thing to note: monetary inflation will affect the prices of different things with different time-frames to different extent. In Zimbabwe, it is consumer prices (and stock prices as well) that bore the brunt of monetary inflation. There’s no guarantee that it will affect the prices of property most favourably to property speculators. A very good example will be the US right now- they are experiencing property price deflation and consumer price inflation simultaneously.

    Realtors would like us to believe that property are reliable hedge against price inflation, but in reality, they’re don’t always work out favourably. It is possible for consumer prices to rise much faster than property prices. When that happens, property speculators are stuffed.

    … it would seem quite possible to come out ahead over time

    Yes, the keyword is “possible.” That means it is not always true.

    … is the fact that there are not enough places to rent where this is so

    We would challenge the idea of housing ‘shortage’ that is often announced by the mainstream media propaganda. More details at Myths on the Australian housing/rental crisis & its implications. In fact, if there truly is an overall shortage of housing in Australia, why is it that vacant houses increases much faster than population growth from 2001 to 2006? The problem with Australia is not one of outright shortage. Rather, it is a mismatch between supply and demand. For example, some areas of Sydney has over-supply of housing and some areas, there are over-demand.

    And if we have a shortage of houses, because even as we speak, we are not exactly going through a building boom, are we?, would that not mean also that prices should be heading still higher, rather than lower?

    We have an answer for that at Another faulty analysis: BIS Shrapnel on house prices. When we look at hosue prices, we cannot apply simple demand/supply on them as if they are commodities. This is because most house purchase are finance with debt. It is debt that complicates the equation.

    … a glut of properties starts hitting the market.

    Do you know that there are already a glut of properties in some parts of Sydney (e.g. Western Sydney)? In these areas, it is possible to see entire block of brand new apartments unsold. There are a lot of new developments in of brand new housing, and no demand, mainly because of woefully inadequate infrastructure.

    The mainstream media will not tell you that, probably because they are bought off by realtors.