May 112020
 

Why inflation matters

U.S. government bonds in 1990 were paying investors 8% a year. That sounds amazing! Especially for a low risk investment. πŸ™‚ But not everyone was buying them. Why? Because investment returns don’t tell the whole story. The inflation rate that year was 5.4%. That means the real rate of return on those bonds was only 2.6%. Stashing $100 under a mattress would have lost $5.40 in value during 1990. As Ray Dalio says, “cash is trash.”

 

Obtaining a mortgage from an unconventional lender

Earlier this year I bought a rental property and took on a new mortgage at 2.44% fixed interest rate for 5 years. After asking around different banks I decided to use monoline lender MCAP. They deal with broker channels and often have lower rates than the big banks. πŸ™‚

negative interest rate mortgage

Since this is an investment property the interest on the mortgage is tax deductible. My marginal tax rate is about 30%. So my effective interest rate after tax adjustment is 1.71%. But this is the nominal rate. To get the full picture we have to subtract the inflation rate. Last year Canada’s official inflation rate was 2.25%. So my real mortgage rate equals the nominal rate (1.71%) minus the inflation rate (2.25%) which comes toΒ -0.54%.

So I’m effectively paying a negative interest rate. I’m earning 54 basis points to borrow money. Woot! πŸ˜€ Personal finance author Robert Kiyosaki says smart people use debt to get rich. He’s right. I’m growing my net worth by literally having this mortgage.

The historical average inflation rate in Canada has been about 2% annually. Let’s assume it will continue to average 2% for the foreseeable future.

This is bad for my mortgage lender. The asset they are holding (my mortgage) will slowly lose value over time. Fortunately for them the 2.44% interest rate they charge me is still higher than the expected inflation rate.

 

What does a negative mortgage rate mean for me?

As a borrower, an inflation adjusted negative interest rate simply means this mortgage is creating wealth for me. πŸ™‚
Here’s how it works:

  • Let’s say my initial loan balance is $1,000 to make calculations easy.
  • My after tax interest rate is 1.71% as mentioned earlier. So my cost to hold this debt is $17.10 this year.
  • Assuming I don’t touch the principal, by the end of this year my loan balance should still be $1,000.
  • But it will only be worth $980 because $20 or 2% will be eaten away by inflation.

In conclusion, this year I will pay $17.10. This comes out of my savings or assets. But I will receive $20.00 from inflation – reducing my liabilities. The difference is a net gain of $2.90 to my net worth. πŸ™‚ I’m essentially giving up cash in return for devaluation of debt, and coming out slightly ahead. If I didn’t borrow this $1,000 in the first place I wouldn’t have made the $2.90 gain. Being in debt generates wealth. Being completely debt free doesn’t. This is how borrowers get rich with a negative interest rate.

Of course a mortgage payment contains both principal and interest, where the principal paydown is forced savings for the borrower. A more accurate calculation would also involve discounting each future payment for inflation separately. But to demonstrate my point I simply used a simplified Fisher approximation.

A new reason to borrow money

Some time during the last decade there was a paradigm shift in the way investors use credit. In the past using financial leverage only made sense if the asset you plan to buy has a higher expected rate of return than the cost to borrow money. But today it’s possible to borrow at negative interest rates in real terms. This changes everything. It means the debt itself generates a real return for the borrower – irrespective of how the corresponding asset performs. If the asset provides a positive return as well then that’s just a bonus. πŸ™‚

Who knew that a liability such as a mortgage can actually be a wealth building tool? πŸ™‚ Not only is my new rental property producing monthly income, but I’m also receiving financial value from the loan I took to buy the property. Double win. Welcome to Modern Monetary Theory. We’re living in some strange times.

 

____________________
Random Useless Fact:

Financial jealousy is when you want someone else’s money. Financial envy is realizing you can’t have the money so you don’t want someone else to have it either.

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Ray
Ray
05/11/2020 7:01 am

Thanks, this was very eye-opening. I recently looked at MCAP rates but stayed with my old big 5 banks just because the paperwork was too much and the 0.5% difference didn’t make it interesting. Either way, that makes sense now and when you said negative mortgage I totally thought something else. Stay safe.

Guy Langevin
Guy Langevin
05/11/2020 11:05 am

Liquid, nice post and a good read as usual.

I’ve essentially used this “leveraging” method for years to generate wealth starting from basically nothing to multimillionaire status today (44 yrs)

Back in 2005 I started buying townhouses in the east GTA Ontario and continued saving hard to buy more. (6 townhouses) – one every ~2 years or so.

Today those properties are all about paid off. I will soon be able to live off the rental income or sell the properties to live off a broadly diversified index portfolio and dividends.

From my own experience, real-estate got me where I am today, mostly because of leverage. I also own a broadly diversified index portfolio but those stock market gains can’t even be compared to the real estate gains when you factor in leverage. (e.g when leverage is used wisely and prudently).

Thanks

Jukka
Jukka
05/11/2020 11:26 am

The interest rate on my mortgage is only 0.4%. After tax deductions and bank bonuses, the real interest rate is only 0.15%.

Get Rich Brothers
05/13/2020 6:06 pm

Enjoyed the read. I think inflation must be one of the least understood concepts out there in personal finance. Since you don’t see it so easily when looking at a spreadsheet (typically because most people would never even think to include it), it goes unnoticed and unplanned for.

When you have more dollars chasing the same amount of goods, the nominal value of those assets must rise. Well done on getting it to work for you with the low interest rates available today.

Take care,
Ryan

Abigail
Abigail
05/27/2020 3:40 am

Congratulations! Nice post and an amazing read.

Jeff
Jeff
07/08/2020 8:43 am

Great post! I recently jumped into the rental property game at 2.79% so this makes me feel even better about doing it!

P.S. Lost the bookmark for your site and am going back to read a bunch of posts now!