The UK inflation rate is down to 2.3% [1] in CPI terms. The RPI inflation measure has fallen to 3.3%. Either way, the pound has stopped losing purchasing power like a proverbial drunken sailor on shore leave. This end to our run-in with runaway inflation is to be welcomed – but maybe with a wistful sigh from those of us who enjoyed seeing our mortgage inflation hedge in action.
Popular culture spent much of the 2010s debating how to survive the zombie apocalypse.
But it was actually inflation that rose from the dead to cause chaos:
[2]CPI measure, source: BBC [3]
Nearly everything got more expensive. The government subsidised household energy bills just to keep the lights on!
Meanwhile the pace of the rise in interest rates due to this inflationary upsurge was shocking. In less than two years we went from nearly-free money to the official Bank Rate at 5.25% and a bond market rout [4].
Those who didn’t stress-test [5] their mortgage have felt extra pain if they left it too late to get a cheap deal.
And those who retired into a terrible [6] sequence of returns haven’t exactly been laughing, either.
When you really get down to it
We’re all potentially made poorer in real terms1 [7] by inflation.
When £100 isn’t worth what it was three years ago, neither is £100,000 in your pension.
To have the equivalent spending power of £100,000 in January 2021, you’d today need £131,000.
Note on numbers: I’m old-fashioned and have used an RPI inflation calculator [8] from Hargreaves Lansdown, which is based on ONS numbers. You might argue it’s better to use the CPI figure these days, especially given CPI is the measure watched by the Bank of England. To do this you can do your own sums using the BOE’s inflation calculator [9]. But without getting all conspiracy theory about it, I’m inclined to go with the higher measure of inflation (RPI) while we still have it.
In real terms, a typical UK private investor’s balanced portfolio is back to where it was in 2016, according to the consultants ARC:
[10]Source: Trustnet [11]
The benchmark here is ARC’s own [12] ‘Steady Growth Private Client Index’, which it says is based on the most common risk profile run by discretionary managers. Something like an expensive-ish 60/40 portfolio I’d imagine. (The indices are proprietary and for clients only).
This Steady Growth Index has delivered a 4% real return since inception. But ARC calculates it must achieve an annual return of 7.3% above inflation for a decade, to get back to the real terms trend line.
Ouch! Come back money illusion [13], all is forgiven!
Still, it’s not all been bad news.
Crucially and as a direct result [14] of the bond crash, expected returns from fixed income are now positive and arguably quite attractive. That augurs well for today’s retirees.
Wages have risen, too. As the cost-of-living crisis abates, most of us saving for retirement should be able to increase our pension contributions.
But make no mistake, inflation has done a number on your number [15]. You’re probably going to need a bigger pot.
The mortgage inflation hedge
Coaxing my ambling donkey back around to the topic of today’s post, a key bit of good news for anyone with a lot of debt is that their debt is almost certainly no longer worth what it was a few years ago.
Specifically, if you had a big mortgage ten years ago, then you may well still have a pretty big mortgage in nominal terms today.
But in real terms, its value is much diminished.
Caveats abound, naturally.
If you took out a big debt at a very high interest rate and didn’t pay it off, then it may have snowballed into an even bigger debt – even after inflation. Something like carrying a credit card balance that charges a double-digit interest rate that’s never paid off would fit this bill.
If you’ve had to refinance at much higher rates, that’s bad too. (Commercial property owners, I’m looking at you.)
However for a very long time, residential mortgage rates have flirted barely above the inflation rate – and lately well below it.
This has made the real terms cost of carrying mortgage debt roughly zilch, thanks to the very same value-eroding force – inflation – that’s been melting your purchasing power elsewhere.
Golden years
This was exactly why I badly wanted a mortgage in the post-financial crisis years.
Not just to buy my own home, but for the ability of debt to hedge against inflation.
Back in 2013 in a post titled Can you afford NOT to have a big cheap mortgage? I wrote [16]:
…anyone who thinks a mortgage is bad news when inflation is running high is wrong.
An affordable mortgage secured on a real asset – a house – is an excellent thing to have at times of high inflation.
In 2013 inflation was headed towards 3%, which was enough to prompt my article that year. But even after that inflation spike proved short-lived, interest rates and mortgage rates continued to fall.
My fellow citizens were getting richer on free money. Meanwhile as a saver without any debt to my name, I was at risk of seeing my net worth being – relatively-speaking – financially-repressed away.
Long story short, I was itchy to get a mortgage – which I eventually did [17] – for its inflation-hedging reasons almost as much as to buy my own home.
Down with debt
Here’s how this mortgage inflation hedge bolsters your finances in real terms.
Real value of debt decreases: Inflation reduces the real value of debt. Even if the amount you owe stays the same in nominal terms. Over time your mortgage becomes worth less and it’s easier to pay off.
Asset appreciation: If you own a home, its value should rise with inflation over the long-term. (UK house prices have risen by more than 3% over inflation for many decades.) As the nominal value of your house and other assets goes up and the real value of your debt goes down, your real net worth grows.
Any mortgage offers these benefits versus inflation. But a fixed-rate mortgage is especially handy.
With a fixed-rate mortgage, your monthly payments remain constant over the mortgage term. That’s at least two years, often five years, and potentially ten years or more. (It’s for the life of the mortgage in the US.)
Even as inflation causes other prices, costs, and your wages to rise, your fixed-rate mortgage payments do not increase. This means in real terms the cost of your mortgage payments decreases as the value of money diminishes. Like this your mortgage becomes more affordable on a monthly basis.
Of course interest rates will likely rise in response to inflation. That puts upwards pressure on variable mortgage rates and makes remortgaging more expensive too. More on that in a moment.
Mortgages are not risk-free! [18] But that doesn’t stop them being a hedge against inflation.
How the mortgage inflation hedge works in practice
Suppose you have a £300,000 repayment mortgage on a fixed interest rate of 3%. For simplicity’s sake we’ll assume you took out one of the new super-long term fixes [19], set to run for 30 years.
Your monthly payments will be £1,265. However if inflation averages 3% per year, the real value of this fixed payment will decrease. In 10 years, it would be just £941 in today’s money.
Meanwhile the value of your home will almost certainly increase, given enough time. The price could more than double in 24 years with just 3% annual appreciation due to inflation.
By then you’d have a £600,000 home and only £83,000 left on your mortgage – which will feel like about £41,000 in today’s terms. Your monthly payments in terms of today’s money would be barely £600.
Here’s one we made earlier
We can also consider the inflation spike of the past few years.
Inflation – per the RPI measure [8] of the cost of goods and services – was 32% between January 2020 and April 2024.
Ignoring any repayments made to reduce the mortgage balance, a £300,000 debt in 2020 is worth around £227,000 in today’s money.
Inflation has effectively reduced the debt by £73,000 – in terms of 2020 money – for you.
Bluffer’s tip! Just in case you ever find yourself stuck in a lift with a professional economist, the technical term for this is ‘Inflation-Induced Debt Destruction’.
A slightly absurd example to make the point
If this feels difficult to get your head around, let’s imagine extreme inflation of 900%.
We’ll say you’ve bought a £100,000 home with a £50,000 mortgage, for a 50% loan to value ratio.
Let’s also assume your house price keeps up with inflation, and we’ll ignore any mortgage repayments.
Your £100,000 home is worth £1m after 900% inflation. Your £50,000 mortgage is still £50,000 but it’s real terms value is now just £5,000.
The real value of the mortgage debt has fallen to a tenth of its original nominal value, even as the nominal value of the asset secured against it ten-bagged. Your loan to value ratio is now just 5%, because the house price rose with inflation but the mortgage balance didn’t budge. You are now rich in home equity!
Played out over several decades, this is exactly how your grandparent’s semi-detached house that they bought in their early 30s made them [20] a modest fortune.
Other things to think about
What would a Monevator article be without a bushel of yeah buts? (Besides about 1,000 words shorter…)
Interest rates: The efficacy of a mortgage as an inflation hedge depends on the interest rate environment. If you lock in a low fixed-rate just before a period of high inflation, you’ll benefit greatly. Take out a mortgage at a high rate when inflation is behaving itself and the benefits are less pronounced.
Variable-rate mortgages: With these, the interest rate on your loan will very probably increase during an inflationary spike. This can partly or totally negate the benefit of a mortgage as an inflation hedge.
The risk of remortgaging a fixed rate: As per the variable rate mortgage, only more of a tense psychological thriller with a shocking climax versus a variable rates’ slasher flic thrills. If you come off a cheap fixed rate deal and take out a much more expensive one, your debt pile is again growing more rapidly and costs more to service. And again your hedging is blunted. (Plus it feels awful [21].)
Not a perfect hedge: I’m using the term ‘hedge’ in a way that will annoy some purists. Inflation does reduce the value of debt in real terms immediately. But assets bought with a mortgage won’t simply rise in lockstep. House prices and stock markets wobble around in the short-term. Think long-term for the full benefits to play out.
It’s the economy, stupid: Some readers have been shaking their heads throughout this article. What about the risk of not being able to pay your mortgage? Or of losing your job? High inflation usually coincides with other economic disruption that could render the strategy moot. All true. You could sell your house in a pinch – but if house prices have crashed in the chaos it might not solve the problem.
Your house isn’t the whole story: A recurring theme of my posts about mortgages (for example [22]) is all this stuff is fungible. You have secured a mortgage on your home, but if you have investments elsewhere, then they are effectively being funded by [23] the mortgage (because you could sell them to pay down your mortgage instead). And these assets could go up due to inflation in their own right, too. That may offset the pain of, say, stagnant house prices or higher mortgage payments.
Remember, a mortgage is just a way of funding a house purchase. People conflate choosing to run a mortgage with ‘gambling on property’. But once you’ve bought your home, the value of that asset – your house [24] – will fluctuate, independently of how you funded it. Through this lens you’re ‘betting’ on house prices, but that’s regardless of whether you have a mortgage or not. What matters with respect to risk and the mortgage is whether you can afford to make your payments. Read my post about my interest-only mortgage [25] to unpick this further.
Rents rise with inflation, too: UK rents have soared along with inflation over the past couple of years. In fact 2023 saw a record [26] 9% hike. Paying off your mortgage and owning your own home will protect you from rising housing costs due to inflation and higher interest rates, obviously. But avoiding home ownership altogether to rent instead will not.
Deflation: In a scenario where money gets more valuable every year, you don’t want to owe it to anybody. Consider getting rid of your mortgage ASAP if you believe deflation is going to stick around!
Waking up to the real world
Reading all this some of you may be thinking “no shit Sherlock”, as you roll your triple-levered pork belly futures into call options on GameStop to play the gamma of meme stock legend Roaring Kitty slowing down his rate of posting 1980’s callbacks on his reactivated social media account.
(Everyone else: it’s fine not to understand that sentence. It just means you’re well-balanced and normal).
It’s true that Monevator readers do bat high versus the general populace when it comes to this stuff.
But most normal citizens do not understand the beneficial impact of inflation on debt.
Earlier this year, The University of Chicago’s Booth School released: Households’ Response to the Wealth Effects of Inflation.
The paper [27] found:
On average, households are well-informed about prevailing inflation and are concerned about its impact on their wealth; yet, while many households know about inflation eroding nominal assets, most are unaware of nominal-debt erosion.
Once they receive information on debt-erosion, households view nominal debt more positively and increase estimates of their real net wealth.
This isn’t just a matter of academic interest. The – um – interested academics found that decisions about spending and debt changed when households better understood the impact of inflation.
Admittedly the boffins looked at Germans. Fears about debt remain embedded in that national psyche. And muted house price growth and a strong rental sector mean Germans don’t grow up on a televisual diet of property porn.
Then again, the study looked at mostly better-educated Germans, a majority of whom had mortgages.
That barely a third realised how inflation benefits those with debts is telling – and a finding I’m sure would carry to the UK and beyond, too.
Mortgages, houses, and hedge rows
Summing up, having a sufficiently chunky mortgage can be an effective hedge against inflation because inflation reduces the real value of that debt.
What’s more, the money raised by the mortgage will typically be invested in assets that can go up with inflation, such as – duh – a house but also other real assets such shares.
The mortgage inflation hedge works best when interest rates are low relative to inflation.
And as always there are risks, particularly with variable-rate mortgages and the broader macro-economic backdrop.
Carrying a big interest-only mortgage was a good financial move for the past 15 years. What’s more, this looked very likely in advance, given how governments and Central Banks were behaving – though other outcomes were certainly possible.
We might have seen deflation, say, if we’d seen the 1930s-style playbook that some pundits now say should have been employed instead of Quantitative Easing, for instance. Or perhaps a global depression in an alternative-universe pandemic. Both would have been bad for debt holders.
So we should beware hubris, carefully size whatever risks we take, and avoid going all-in on anything.
A mortgage is not for everyone, but…
As we repeatedly stress on Monevator, one size never fits all.
Besides the financial issues, some people just hate the idea of having a mortgage. They don’t want a bank having a claim on their home or monthly mortgage payments stretching off to the far horizon.
Which is absolutely fair enough.
Paying off a mortgage will never be a bad financial move. Even if you’re rich, say, and all that zero-ing your mortgage balance does for you is help you sleep at night, that’s still worth a lot.
But by the same token not having a mortgage often won’t be the best financial decision, given its relatively low cost versus other productive uses for the money.
Running a mortgage has other benefits beyond enabling you to buy a house. And inflation-hedging is on that list for me!
- Real terms means numbers after inflation is taken into account. [↩ [32]]