The Consumer Price Index for 2021 was just announced: inflation last year ran at a 39-year high of 7%, marking a big change from more than a decade during which policymakers couldn’t manage to bring inflation up to about 2%-3%. While the reduction in purchasing power varies tremendously depending on what you’re spending on—energy prices rose 29.3%, but everything else rose 5.5% on average—the news isn’t all bad. The same period saw the S&P 500 rise by almost 27%.
Many investment professionals point to stocks (and mutual funds that own them) as a good way to protect against inflation. But they often miss how this can be enhanced by owning your own home, especially with a 30-year fixed-rate mortgage. And for many people, the bigger the mortgage, the stronger your inflation protection.
Three interconnected ways your mortgaged home protects you against inflation
1. Using a mortgage leaves you more money to invest.
Suppose you want to buy a $250,000 home. You could take it out of your savings and investments and pay all cash. But this would leave you with $250,000 less in liquid assets to grow for you. You might even end up house-poor this way. Fortunately, you could borrow 80% of the purchase price using a 30-year fixed-rate mortgage. This leaves $200,000 more in your savings and investments to provide financial stability and grow.
Neither approach gives you more net worth than the other: paying cash gives you more equity in the house and less in your portfolio. Taking the mortgage does the opposite. But using the mortgage means you keep more in liquid assets that you can invest for the future.
Some object to this approach, saying that the increased monthly spending for the mortgage cancels out the benefit of having more in savings and investments. We generally find this isn’t true: most of the time, the savings and investments grow in the long run by much more than the cost of the interest on the mortgage.
(And why not a 15-year mortgage with its ¼% or so lower interest rate? Because the monthly payment is much higher, forcing you to pay off the mortgage more quickly and more rapidly eroding the inflation hedge that your savings and investments provide.)
2. A fixed-rate mortgage stabilizes your housing costs.
Housing costs are a substantial part of most people’s expenses, often making up about 25% of total monthly spending. With a fixed-rate mortgage, this cost is relatively stable, varying only with fluctuations in expenses like property taxes, insurance, and upkeep.
If inflation is driving up your earned income or your investments are increasing in value, the relatively fixed housing cost will make up a smaller and smaller part of your purchasing ability. This means your purchasing power is increasing, counterbalancing at least some of the effect of inflation on your other expenses.
3. Your home is an appreciating asset.
Of course, the value of your home itself likely is increasing in an inflationary environment. If it rises to $300,000, and you paid $250,000 in cash, you’ve got a 20% return on what you put into the house. But if you’ve taken a mortgage that allowed you to put down only $50,000 on your home, the $50,000 appreciation is a 100% return on your equity.
Isn’t that return reduced by the principal you’re paying on the mortgage? Sure, but it’s a tiny bit every month compared to the total borrowed, leaving you much more in savings and investments.
If the home appreciates in value, why not prefer that instead of the investment portfolio? Your investments are much more liquid—it’s a great deal more difficult to get money out of the equity in your home than it is to sell some mutual funds.
What if inflation runs at a rate greater than stock market returns? Anything’s possible, but in the long run, we’re confident the stock market should far outpace inflation.
Your own home is a better investment when you use other people’s money (and for most of us, it’s the only thing that we should invest in with borrowed money). If you own your home free and clear, you can evaluate whether or not a cash-out refinance would be enough of an advantage to justify a new 30-year fixed-rate mortgage.
This is really about teamwork, having the right kind of asset do the job it’s best suited for.
- Your home’s job is to provide shelter. It will do this job just as well regardless of how much money is borrowed against it. Coincidentally, most homes will also appreciate in value, but they tend to cost a lot compared to your regular income.
- The job of your investment portfolio is typically to strike a balance between growing and reliably retaining its value. The more that’s growing in your savings and investments now rather than later, the greater value you will eventually have.
- Your mortgage’s job is to give you a way to buy a house when you can’t (or don’t want to) take that much money from either ongoing earnings or savings and investments. You likely have the option to select a 30-year fixed rate, keeping the demand on your cash flow to a minimum while having the benefit of a predictable monthly loan.
The result of this strategy leaves more value available to invest than otherwise and limits the amount your housing cost can increase when other prices, and your home’s value, rise.
(Of course, be sure to consider not just the financial effects of this strategy, but whether or not you’ll be bothered by owing money on your house. The numbers usually support a competitive 30-year fixed-rate mortgage, but you may derive enough satisfaction from not having a monthly payment that it could be worth it to you to keep the house paid off. You’d miss the enhancement of your inflation hedge, but if you find you sleep better at night, that’s hard to argue with.)
Other factors go into whether this is the best strategy for you. And this approach may seem quite simple, but financial planning doesn’t always have to be complicated in order to work.
Keeping more of your net worth in your liquid savings and investments, and less in your not-so-liquid residence, is usually a good hedge against inflation. Your financial planner can help you evaluate whether this strategy is the right approach for you.
Copyright © 2022 by Practical Financial Planning, Inc.