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Inflation, Interest Rates & Mortgages: What Effect Do They Have on Each Other?

By Chika

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Last Updated: October 6, 2021

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When we think of inflation, we usually associate it with the rising cost of consumer goods such as gas, groceries, foodstuff, etc. Amongst other things, inflation also affects mortgage rates.

Since we spend as much as 28% of our income on a mortgage, it is important to know how inflation affects our dreams of owning a home.

Understanding how the economic cycle affects different types of home loans could help us to time our mortgage applications appropriately and target periods with low mortgage costs. Such knowledge comes in handy especially as the Federal Reserve could begin raising interest rates soon.

 

What is inflation?

Inflation is simply defined as an increase in the prices of goods and services over a period.

This rise in the price signifies that the currency is losing value, as the consumer can purchase fewer items with the same amount of money.

For example, if inflation rises by 2%, that means your money has lost 2% of its value because the cost of goods and services has risen by that same amount.

On the flip side, when inflation drops, this means the currency is gaining value because goods and services are cheaper.

Depending on the catalyst, inflation may be short or mid-term. A rise in demand for goods, or an increase in the cost of production can lead to inflation in the short term.

Changes to monetary policy from the central bank can cause kind term inflation. Inflation can also be long-term, but this is usually the fallout from the inability of the central bank to tackle short or mid-term inflation.

 

How do inflation and interest rates affect each other?

Interest rates reflect the cost of using someone else’s money.

Lenders charge interest to borrowers who take out loans and lines of credit as a premium for the right to use the lender’s money. During inflation, money is more valuable in the present than in the future.

This is why inflation and interest rates move in tandem.

This is because lenders would demand greater compensation for their money for the value lost during the tenor of the loan. On the flip side, when the inflation rate is going down, interest rates are lower because lenders are sure that their money would retain its value during the loan tenure.

The central bank is in charge of setting interest rates. It does this by monitoring inflation rates in the economy through metrics such as the Consumer Price Index (CPI) and Producers Purchasing Index (PPI).

  • CPI = what consumers are paying for goods and services
  • PPI = shows the cost at which producers are manufacturing goods

When the inflation rate rises above the central bank’s target (usually 2%), the apex bank raises interest rates to control inflation.

A higher interest rate increases the cost of borrowing, which discourages individuals and corporations from borrowing money. This inadvertently reduces the amount of money in circulation because people are borrowing less and saving more.

With less money in circulation, it reduces the demand for goods and services causing their prices to fall and the economy to stabilize. Likewise, when the economy is slowing down, the central bank can lower interest rates to encourage borrowing and spending.

 

How inflation affects mortgage rates

As we can see, as inflation rises, the central bank (Federal Reserve for the United States) raises interest rates.

This increase in interest rates affects interbank lending rates, which makes interest on loans such as mortgages go up.

Fixed-rate mortgages track the yield on the 10-year Treasury bond. As this goes higher, so does the mortgage rate and vice versa. As such, prospective homeowners should keep an eye on the 10-yr Treasury bond yields to track the prevailing interest rate.

Inflation may also affect mortgage rates through the cost of materials and labor.

For example, if the price of lumber goes up, this would lead to higher production costs for home builders who pass these costs to the final consumer, the homeowner.

As such, the homeowner would have to pay more. However, the major factor that determines mortgage rates is the benchmark interest rate set by the Federal Reserve based on the prevailing economic condition.

Another factor to bear in mind is how inflation affects your debt-to-income ratio.

This metric tells lenders how much of your income goes into servicing debts. It's calculated by adding all your monthly debt payments and dividing by your gross monthly income. Lenders look for a DTI ratio of 43% or lower.

During periods of inflation, your DTI ratio tends to increase. You're spending more money on debt payments due to higher interest charges. But your income essentially stays the same, leaving you with less money to spend on necessities.

Applying for a mortgage during a period of inflation can limit your chances because you would have a higher DTI ratio compared to when there's little or no inflation in the economy when interest rates are low.

 

When is the best time to apply for a mortgage?

Timing your mortgage application is crucial because this can determine how much you pay for your home.

Mortgages are cheaper during periods of economic downturn. This is because rates would be lower as the Federal Reserve would be trying to encourage spending and borrowing to stimulate growth. As such, taking out a mortgage during this period is usually cheaper. 

However, during periods of economic boom and the resultant inflation, taking out a mortgage would cost you more because you would be paying a higher interest rate.

As the cost of goods and services is rising, the money loses purchasing power.  The central bank then has to raise interest rates to discourage spending and borrowing, compensating investors for saving their money.

 

Final word

Owning a home is a huge milestone. It's usually one of the biggest financial decisions one makes in their life!

Understanding how inflation affects mortgage rates can help us to know the best time to buy a home. This helps us make more affordable contributions towards owning your home. It also saves us extra cash to be invested in other ventures that would increase our returns.

Knowing the economic cycles is crucial in making decisions towards homeownership.

However, to effectively pull this off, you need to have enough firepower. This implies you have to have cash saved up and keep the economy on your radar to be able to take full advantage when interest rates fall. 

Photo by RODNAE Productions from Pexels

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