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Inflation, equity buildup, and payment burden - YouTube
Channel: Marginal Revolution University
[1]
I wanna talk about how inflation
affects the borrower.
[5]
So we're back to a spreadsheet.
[6]
This is the spreadsheet that I used
to create the guess and check
[10]
but I've added three more columns.
[12]
The first column is for the house price
[16]
Which will go up with the general rate
of inflation
[19]
and the next column is the
borrower's equity.
[23]
Which is the house price minus
the unpaid balance.
[27]
And then we have the borrower's
payment income ratio.
[30]
I assume the borrower has
$30,000 of income
[34]
and that the income will go up
with inflation
[37]
So right now I have inflation
that parameter set to 0.
[42]
And as a result this isn't
terribly interesting.
[46]
The house price just stays the same
[48]
and the payment income ratio stays
just the same.
[52]
And the equity, the borrowers equity
builds up very slowly.
[57]
Notice after 10 years the
equity is only $17,000
[63]
Ok now I'm going to change
the inflation rate to 2%
[67]
Lets watch what happens.
[69]
Particularly the borrowers equity which was
[71]
after 10 years was $17,000
without inflation
[75]
is now $36,000
[76]
so the just the 2% inflation rate
[81]
more than doubles the equity build up
for the borrower.
[85]
So they really build up
a lot of equity
[89]
and you noticed that their
payment income ratio
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If assuming that their income
[93]
goes up with inflation steadily declines.
[96]
So at the start it's 20% of their income
[102]
by the 12th year it's down 15% of their income.
[107]
So that you get a
[110]
For the borrower
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inflation appears to be a
good thing
[116]
However, you got to be careful about
that because what we've been
[121]
assuming is that the nominal interest rate
[124]
is constant while the inflation rate went up.
[128]
Suppose we keep the real interest
rate constant.
[131]
That is the difference between the
nominal interest rate and inflation.
[136]
So lets start with a 2% inflation rate,
5% interest rate which is a
[142]
3% real interest rate.
Lets keep a 3% real interest rate
[147]
but raise the inflation rate
to 4%.
[150]
So that means the nominal interest rate
will go to 7
[155]
And the inflation rate will be 4.
[164]
Okay
[165]
What happens there is that
the borrower equity
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builds up even faster.
[172]
So with the higher
nominal interest rate
[175]
The borrower now has 56,000
in equity.
[179]
Whereas there were only
they only had 36,000
[182]
with 2% inflation and we had 0% inflation
they only had 17,000.
[188]
So this is a big jump in the
borrower's equity
[192]
and the payment income ratio
which was 20% before to start with
[200]
is now 24 % it still drops off dramatically
[204]
down to 15% by year 12
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but it starts out very high
[211]
and that's because with the
higher interest rate
[215]
the monthly payment
is higher.
[218]
And it takes awhile for the borrower's
income to catch up.
[222]
So that's something to think about
the effect of inflation
[226]
for the borrower.
[228]
Basically
the key points to remember
[230]
are that as the nominal
interest rate
[235]
Sorry, as the inflation
goes up
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keeping the nominal interest rate
constant
[240]
It's unambiguously
better for the borrower.
[242]
The borrower gets more equity
and a nice drop in the
[246]
payment income ratio.
[249]
If when inflation goes up
the real interest rate remains constant
[254]
so that the nominal interest rate
rises its not quite as good
[258]
for a first time borrower.
[261]
coming to buy a home because
that payment income ratio
[265]
goes up
[265]
And I'll talk about it that more in a
subsequent talk.
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