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Inflation's Upside: Rising Prices Help Tapped-Out Homeowners
Message to homeowners: Pray for inflation.
To be sure, low inflation has been a bonanza for the housing market. The accompanying decline in mortgage rates has allowed folks to buy bigger homes and to slash their monthly mortgage payments by refinancing.
But low rates have also encouraged many homeowners to overdose on mortgage debt, leaving them with precious little home equity. For these folks, renewed inflation could be their financial salvation, allowing them to rapidly build home equity, while stagnant inflation or even deflation could be a disaster. Puzzled? Bear with me while I explain.
Drowning in Debt: According to the Federal Reserve, mortgage debt jumped 12.4% last year and has climbed 9.7% annually over the past five years.
Low mortgage rates have made all this borrowing not only possible, but also necessary. The reason: Low rates have fueled a sharp rise in home prices, which are up 39% in the past five years, according to home-finance corporation Freddie Mac. With houses increasingly expensive, many home buyers have had no choice but to borrow more money.
The surge in mortgage debt also reflects a growing fondness for second mortgages and cash-out refinancings. As homeowners have refinanced to lock in lower rates, they have taken the chance to cash out home equity, which is then lavished on home improvements, new cars and goodness knows what else.
The problem is, all this debt eventually has to be repaid. As I have noted in earlier columns, it's awfully tough to retire in comfort if you still have to make monthly mortgage payments.
Which brings us back to inflation. To understand why the inflation rate is so critical, check out the accompanying chart. As you will see, home prices have tended to track inflation closely.
But in recent years, the link between home prices and inflation has broken down. In 2001 and 2002, home prices surged 7.5% a year, while annual inflation muddled along at just 2%.
What happened? "Cheap and easy money has driven up demand," explains Chris Mayer, a real-estate professor at the University of Pennsylvania's Wharton School. "But the supply isn't there. In many parts of the country, it's difficult for builders to respond quickly to market signals. Building is not keeping pace with demand."
Still, Prof. Mayer expects the historical pattern will reassert itself, with property prices once again closely tracking inflation. As he notes, there's a good reason this pattern exists. Incomes tend to rise with inflation. That means people can afford to pay more for houses, thus helping to propel home prices higher.
Inflating Your Gains: That still leaves us with a key question. Why is higher inflation better? Suppose you have a fixed-rate mortgage. If inflation picks up, you are likely to end up with more disposable income, because your salary will rise, while your mortgage payments will stay the same.
But there's another, more critical reason to root for higher inflation. High inflation can do wonders for your home equity. Let's say you bought a $200,000 house with $10,000 down, borrowing the other $190,000 through a 30-year fixed-rate mortgage with a 5.5% interest rate. Over the next three years, inflation bubbles along at 6% a year and home prices follow suit.
Compound that 6% over three years and your home would be valued at $238,200. Meanwhile, over the same stretch, your monthly mortgage payments would have trimmed your loan balance to $181,900.
That means you now have $56,300 in home equity, up from $10,000 three years earlier. What if you suddenly had to relocate? Even after paying a 6% real-estate-brokerage commission on your home's $238,200 sale price, you would still be left with $42,000. That's plenty of money to put down on your next home.
Now, imagine the same scenario, but this time there's modest deflation and home prices fall 1% a year, so that your house is valued at just over $194,000 when you go to sell three years later. After deducting the $181,900 still owed to the bank and a 6% real-estate commission, you would walk away with just $500.
"You either can't move or you move with very little equity, which means you could end up being a renter again," says Douglas Poutasse, chief investment strategist at AEW Capital Management, a real-estate investment adviser in Boston.
Of course, if we really did get zero inflation or even deflation, there would be a silver lining. Interest rates would probably decline, allowing folks to refinance and thereby trim their monthly mortgage payments. But if you haven't got much equity in your home, you might have a tough time finding a lender who will let you refinance.
Admittedly, all this is unlikely. With the federal government running huge budget deficits and the economy apparently set to recover, renewed inflation seems far more likely than deflation.
Still, I think it is wise to be cautious. To that end, make a decent-size down payment next time you buy a house. Avoid second mortgages and cash-out refinancings. Consider making extra principal payments, so you pay off your mortgage more quickly. In a weak housing market, your best defense is a healthy amount of home equity.
Updated June 11, 2003
KJC |
