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How Using Debt Can Counter Inflation for the Borrower

This discussion is about the difference between real value versus nominal value. Price inflation is dollar devaluation.


A little about inflation:

Inflation does not change the real value of an object, but it does change its nominal value (which is its price). As an example, the price of a cup of coffee increases as inflation increases, but the real value of a cup of coffee stays the same. Inflation causes prices for the same products to increase because prices are set with nominal dollars.


If I buy a real estate property today, the price is set in nominal dollars based on what a dollar will buy today. If I pay cash for the property, the nominal price and the real price are the same, since all the money is transferred to the seller today. However, if I borrow money to buy a property, the price and my payment amount are fixed using today’s nominal dollars, but since my payment is made in the future with less valuable nominal dollars, I am paying the lender less money every year in real terms.

Said differently, a borrower taking on a fixed-interest rate debt benefits from inflation. As inflation rises, the real cost of the money owed decreases, because the amount paid stays the same even though the real value of the money decreases. This means the borrower is repaying the debt with money that is worth less than when they originally borrowed it. Inflation decreases the real cost of debt.

A little about appreciation of real assets:


Real asset prices increase because of two forces:

1.       A person will pay more for a property when competition with other buyers increases relative to a given level of supply, i.e. when more buyers are seeking the same number, or fewer number of properties, it results in a real increase in price.

2.       Inflation causes the money being paid for a property to be less valuable, so over time a seller requires more money for the same property, increasing the nominal price.

Combined, these two forces cause real estate prices to move consistently and predictably upward.

If borrowed funds are used to purchase real assets like real estate, these assets likely increase in value over time, often at a rate that far outpaces inflation. This means the price of the asset increases while the cost of the debt decreases in real terms. This is a double whammy!


Consider some additional factors enhancing the situation:

1.       If a borrower's income grows at or above the rate of inflation (which often happens during inflationary periods), her fixed-rate debt becomes more manageable because her income has more purchasing power relative to the debt.

2.       The interest paid on mortgage debt is typically tax-deductible either against ordinary wage income or against operating income from the property. Taking advantage of this utilizes a government subsidy to partially offset the cost of debt further.

3.       Real estate owners who combine their available cash with properly structured debt both increase the return on their cash investment and can accumulate a much larger total value of appreciating real estate with a given amount of cash resources.

 

Using inflation’s effect on money to your advantage by placing debt on real property is the true essence of wealth building. Not taking advantage of this due to an outdated belief about money and debt is a mistake.

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