With interest rates rising, you often hear about the struggles faced by households with large mortgages and the “soaring cost of mortgages”. However, inflation is good for people with mortgages and if this is understood, the “soaring costs” of mortgages can be easily offset by re-mortgaging or deferred payments. Let me explain….

The impact of inflation on the economy is a much mis-understood phenomenon. One of the main effects of inflation is to redistribute money from lenders to borrowers. Most loans are not indexed to inflation, and repayments are set in fixed monetary values, which are reduced in real value (purchasing power) by inflation. If the inflation is anticipated, this effect can be reflected in the contract. Short of full indexation, this has historically usually been done by increasing interest payments on the loan to offset the falling value of the loan. The way to do this is captured by Irvin Fisher’s concept of the real interest rate: the nominal rate less inflation. For a given real rate of interest, the nominal rate of interest paid would simply increase with inflation. Thus, for example, if inflation increased from 0% to 10%, the nominal rate would increase by the same amount (for example from 2% to 12%) to keep the real rate constant (at 2% in the example). This arrangement does have the effect of speeding up the repayment of the loan: 10% of your interest payments are in effect paying back the real value of the loan. After a year, the real value of your loan has gone down by 10%.

Interest rates, however, rarely keep up with inflation when it gets high. This has certainly been the case in Britain since 2009 with near zero interest rates until very recently. Even now, interest rates remain well below the inflation rate. If interest rates are kept low by monetary policy (the short rate by the Bank of England policy rate and the longer term rates by QE), then the interest rates certainly will not increase to compensate lenders for the effect of inflation eroding the real value of their asset (loan).

So, for borrowers with mortgages, the effect of inflation is clearly good in the long-run. In effect, they are “inflating away” their debt, the real value of which is declining with inflation. The interest rates they are paying on their mortgages are less than inflation, and so they are clearly gaining, since there is a smaller “cost” in terms of elevated interest payments to offset the gain of the reduction in the real value of debt.
However, there is a short-term cash flow problem that mortgage holders may face. If the interest payments go up, this is a payment which needs to be made out of current income. This can cause problems for households for whom mortgage payments make up a large share of expenditure (for example young families with children). However, the solution to this problem should be simple. If there is a cash flow problem, it can be solved either by the mortgage lender allowing some level of deferred payments or taking out an additional loan to pay the additional interest payments.

Mortgage lenders should be happy to allow people with mortgages to alter the pattern of their repayments in an inflationary environment, since the solvency of the mortgage holders is being enhanced by inflation. The government should encourage mortgage lenders to make such arrangements and not allow them to re-posses houses unless such rescheduling of payments has been tried first. Households should not be made “bankrupt” by a cash flow problem caused by rising interest rates in response to rising inflation which is making them better off and more solvent.

If inflation erodes the real value of loans, why are banks unconcerned about it? This is because their assets and liabilities are largely nominal assets. From a bank’s perspective, inflation is largely neutral: the value of its assets (loans such as mortgages) and its liabilities (deposits held by firms and households) are both affected in an offsetting way. In addition, commercial accounting practice ignores inflation, so a “profit” can be made and reported even if (in real terms) it is a “loss”.

So, next time you hear about soaring mortgage costs due to higher interest rates, remember that the people with big mortgages are the biggest winners from high inflation: “She who borrows, wins”.