The Advantages of Inflation
Today I want to share one of my biggest secrets to success. I will explain how I generate $5,000 of value a year in passive wealth creation using my mortgage and other loans. It’s automatic, hassle free, hidden from my friends and the government, and is completely legitimate. 🙂
The Destroyer of Credit
Everyone knows that inflation drives up the cost of living and lowers the value of money. Thanks to inflation you don’t even need to have expired bread for your dough to be worthless. ? But here’s what some people may not know about inflation. Since money is so closely tied to debt, when our money loses value via inflation, so does our debt. 😀
Think about it this way. Let’s say we owe the bank $100. After a year, if we haven’t touched the principal, then our $100 balance owed will have less purchasing power, assuming a positive inflation rate. Since $100 will be worth less in the future than today, our debt balance will become easier and easier to pay off as time goes on. 🙂
Over the past 12 months in Canada the Consumer Price Index (CPI,) which is a government measurement of inflation, has risen by 1%. Let’s say we took out a $100,000 loan from our home equity line of credit a year ago and made interest-only payments so the balance still stands at $100,000 today. During the past year inflation has eroded the value of both money and debt by 1%. This means our HELOC loan will only be worth $99,000 in last year’s constant dollars. Wow, we just increased our purchasing power by $1,000 in REAL terms by simply sitting on some good ol’ debt. 🙂 Thank you inflation! The more debt we have the more we stand to gain from the effects of devaluing currency. Banks understand that the money they lend will be worth less by the time they collect it back. So charging interest is one way for lenders to combat the effects of inflation.
Last week I disclosed all my personal debts including my mortgage, lines of credit, margin, etc. My total loans stand at roughly $500,000. With the CPI at its current rate of 1%, inflation is literally paying back my debts to the tune of $5,000 every year! 🙂
This is why I blogged about my strategy to pay back my mortgage as slowly as possible as long as interest rates remain low. I wrote that post almost 4 years ago and the arguments made then surprisingly still holds up today.
The Risk of Deflation
I prefer to inflate $5,000 out of debt than to make an extra $5,000 in income to pay down debt. This is because earnings are usually subject to taxation but reducing debt in real terms through the passive use of inflation is tax free. 🙂 But while inflation is a secret wealth building tool for people with debt, deflation can be a pain in the butt. ? Sometimes known as negative-inflation, deflation is when the price of products drop and the value of money increases, often due to a shortage of the money supply. As someone who has a lot of debt, a deflationary environment will mean the value of the loans (money) I owe will be worth more so I’ll have a harder time to pay them down. But deflation is the cat’s pajamas for savers because their purchasing power will rise. 🙂
Government and Central Bank Policies
In an economy of government intervention and currency manipulation it’s absolutely crucial that we familiarize ourselves with the monetary policies set out by central bankers. Their policies tell us what the money supply is expected to do in the future, which can help us make practical financial decisions. For example, the Bank of Canada has maintained an inflation target range between 1% and 3%. If the inflation rate falls outside of this range, the BoC can use a variety of tools to manipulate the inflation rate and keep it controlled. The European Central Bank controls the monetary policy for the Eurozone which is the largest economy in the world. The ECB’s president, Mario Draghi, has set an inflation target of just under 2%. He recently said that if inflation does not meet the ECB’s expectations, the Bank will do everything it can to raise inflation back up as quickly as possible. The U.S. Federal debt is about $18 trillion. And its growing by billions of dollars every day because the government continues to spend more than it takes in.
Given their track records, it is fairly safe to assume that central banks will continue to favor a positive inflation rate environment. It’s easy to understand why. Inflation is a great way to lessen the burdens of national debts around the world. This is important to remember as an investor because certain asset types such as real estate and stocks perform better during inflationary times, while other assets such as cash and government bonds usually perform well in deflationary environments. 🙂
The Risks of Inflation
On the one hand my purchasing power grows by $5,000 a year thanks to inflation. But on the other hand I have $920,000 of assets, so inflation also eats away 1%, or $9,200 of my asset’s value.
This is why it’s important to invest our assets and hopefully get a higher return than the inflation rate. If investment returns do not keep up with inflation then our financial security could be in jeopardy because even if we can consistently make 10% investment returns every year, we will become worse off if our cost of living is going up 20% a year.
Runaway inflation also indirectly causes higher interest rates which would not be fun for people who have variable rate loans. If interest rates rise I will re-prioritize and focus on debt repayment. But my current mortgage rate is only 2.3% and I believe there are attractive investment opportunities with higher rates of return.
Slow and Steady
Most of us don’t feel the immediate impacts of inflation because it happens very gradually. But over time understanding how to use inflation to our advantage can save us big money! For example, debt is a depreciating liability while real estate is an appreciating asset, so buying a home using debt is a double win! 😀
According to the United States CPI chart below, the U.S. dollar has lost about 50% of its value over the last 25 years.
I’ve previously explained the relationship between money and debt and how the two represent different sides of the same coin. There can’t be one without the other.
The rising cost of living can be a nuisance, but it can also be a blessing to people who have debt. I’m not worried about my $500,000 debt because I know its real value will probably drop down to $250,000 in 25 years, lol. ? Understanding how inflation works can help us put things into perspective.
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