Mortgages: Inflation Hedge For Long-Term Property Investors

While taking out a mortgage is often viewed as a hedge against inflation, it is not necessarily the case. Inflation and mortgage rates are connected, and mortgage rates can dramatically rise with inflation. A fixed-rate mortgage can protect against this, as the rate will remain the same regardless of inflation. However, the mortgage itself is not a hedge against inflation, but rather the income sources used to fund it are the actual inflation hedges.

How are mortgages a hedge for inflation?

Fixed-rate mortgages are not a hedge against inflation

Fixed-rate mortgages are often viewed as a hedge against inflation because the monthly payments are locked in and don't change even when inflation increases. However, this perspective fails to consider the impact of inflation on the purchasing power of the borrower. While the nominal value of the mortgage payments remains constant, the real value of each payment is subject to inflation, resulting in a decrease in purchasing power over time.

An inflation hedge refers to an investment that protects against the loss of purchasing power due to rising prices and inflation. In the context of a fixed-rate mortgage, the interest rate and principal payment remain constant, providing a sense of stability for borrowers. However, the real return on the investment, calculated as the nominal return minus the inflation rate, is not fixed. As inflation rates fluctuate, the real return on the mortgage also fluctuates, contradicting the fundamental principle of an inflation hedge.

Additionally, it's important to distinguish between the benefits of owning a residence and the advantages of a mortgage. While owning a home can provide a hedge against rent inflation, this benefit is derived from homeownership rather than the mortgage itself. The mortgage enables the purchase of the residence, but it is the residence that serves as the inflation hedge by eliminating the need to pay rent, which tends to increase with inflation. Therefore, the true inflation hedge is the ownership of the residence, not the mortgage used to acquire it.

Furthermore, the decision to take out a mortgage involves various factors, including the financial mindset and wealth-building goals of the borrower. The process of obtaining a mortgage requires financial discipline, such as saving for a down payment, budgeting for homeownership costs, and managing monthly payments. This disciplined approach to finances can positively influence other financial decisions and contribute to a structured investment plan. However, it's important to recognize that the mortgage itself does not provide a hedge against inflation.

While fixed-rate mortgages offer stability in monthly payments, they do not offer protection against the erosion of purchasing power due to inflation. The distinction lies in understanding that the nominal value of the payments remains constant, but the real value, which considers the impact of inflation, does not. Therefore, it is crucial for borrowers to consider the potential long-term financial implications of fixed-rate mortgages and explore alternative strategies, such as investing in inflation-hedging vehicles or focusing on building financial discipline and wealth-building habits.

Adjustable-rate mortgages are not a hedge against inflation

Adjustable-rate mortgages (ARMs) are not a hedge against inflation. When inflation rises, central banks often respond by increasing interest rates to stabilize the economy. For homeowners, this could mean higher mortgage payments as the interest rate on adjustable-rate loans adjusts upward. Even for those with fixed-rate mortgages, rising inflation might make it harder to keep up with other household expenses, leaving less disposable income for long-term financial goals.

The benefits of a mortgage as a hedge against inflation don't come from the mortgage itself, but from the other inflation-adjusted assets and income an individual has to support the mortgage. For example, a mortgage may be paid off with inflation-adjusted wages, freeing up funds to be invested in inflation-hedging vehicles such as TIPS or equities. It can also be used to create a reserve for investing in bonds at higher rates in the future or to purchase a residence that provides a hedge against rising rents.

In addition, refinancing into a fixed-rate mortgage can serve as a hedge against inflation. By refinancing, borrowers can lock in today's lower interest rates and protect themselves from the higher rates that typically follow inflationary periods. This ensures that their mortgage payments remain stable even as other costs rise.

While a mortgage is often viewed as an inflation hedge due to its fixed payments that don't change with inflation, the reality is that a mortgage alone doesn't benefit from inflation. It's not necessarily harmed by inflation, but it doesn't provide a benefit either. The expected return on real estate properties may include an inflation premium, but it's not fixed, and there is also a lot of idiosyncratic risk.

Therefore, while a mortgage can provide access to beneficial outcomes during inflation, it is not a hedge against inflation in and of itself. The benefits come from the other assets and income used to support the mortgage.

Homeownership is a hedge against inflation, not mortgages

Homeownership is a hedge against inflation, but mortgages are not. This is because, as a homeowner, you can lock in what is likely your largest monthly payment, your mortgage, for the duration of your loan. This helps to stabilise some of your monthly expenses. As home prices continue to appreciate, your home's value will too.

While a mortgage is often viewed as an inflation hedge, due to its fixed payments that don't change even if inflation arises, the reality is that a mortgage alone isn't a hedge that benefits from inflation. It's not necessarily harmed by inflation, but it's not a benefit either. This is because, in order for a loan or mortgage to be a hedge against inflation, the real return of that loan has to remain fixed. There are currently no inflation-linked loans or mortgages available to retail investors.

Homeownership, on the other hand, is a hedge against inflation. This is because it provides a hedge against rent inflation. As a homeowner, you benefit from rising wages, which offsets the cost of living. Additionally, the financial mindset that helped you become a homeowner is likely to impact other financial decisions, such as saving, spending and investing.

However, it is important to note that homeownership is not always a hedge against inflation. If you stretch your budget or drain your savings to buy a home and then lose it because of job loss or other circumstances, this can impact your credit and budget for many years to come. Therefore, experts advise that borrowers buy a home well within their budget.

Mortgages can free up funds to invest in inflation-hedging vehicles

While a mortgage is often viewed as an inflation hedge, it is not an inflation hedge in itself. However, it can free up funds to invest in inflation-hedging vehicles.

A fixed-rate mortgage, for example, guarantees that your rates will not rise as inflation continues to impact the economy. In contrast, a mortgage's interest rate (or loan) is the bank's return and your cost. This is important because it allows us to compare a mortgage to a commonly used fixed-income security to hedge against inflation, such as inflation-linked bonds. As a result, if you invest in such a bond, your real return is fixed, and your purchasing power increases remain fixed.

For a young household with few financial assets, a mortgage is a good deal because a smaller proportion of each paycheck is required to make the payments, assuming pay increases with inflation. For a household with significant financial assets, the answer is not as clear-cut. The balance-sheet perspective provides a holistic view by focusing on the assets and the debt financing those assets.

Mortgages can also be paid off with inflation-adjusted wages, freeing up funds to be invested in inflation-hedging vehicles. For example, a homeowner can use their proceeds to buy a series of laddered bonds with a comparable yield to secure each mortgage payment. This "perfect" asset-liability matching effectively immunizes against any risk that a change in interest rates could adversely impact the situation.

Mortgages can be paid off with inflation-adjusted wages

While a mortgage is often regarded as an inflation hedge, it is not actually an inflation hedge in and of itself. A fixed-rate mortgage, for instance, will not be an inflation hedge because the real return on the investment is not fixed. The interest rate on the mortgage remains fixed, but inflation rates fluctuate, so the real return fluctuates.

However, mortgages can be paid off with inflation-adjusted wages. For young households with few financial assets, a mortgage can be a good deal because a smaller proportion of each paycheck will be required to make the payments, assuming pay increases with inflation. In addition, the benefits of owning a residence to hedge against the impact of inflation on rents are a function of owning the residence, not a function of having a mortgage.

In addition, a mortgage can free up funds to be invested in inflation-hedging vehicles, such as equities, or be used to create a reserve for investing in bonds at higher rates in the future. It can also be deployed to purchase a residence that provides a hedge against rising rents.

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