Inflation/Deflation Discussion - Are Low Interest Loans Worth Keeping?

[knince]

I am hoping to promote a healthy fact-based discussion of our inflation assumptions with this thread. Specifically, I would like to pose a question for the Mustachian community regarding US Inflation forecasting. Having a BBA in Finance and an MBA, I am aware of the basic economics. I want to delve into the details here.

We often presume that debt at a fixed interest rate of ~3.5% or below is beneficial as a hedge against inflation. However, the US experienced DEflation in 2009 and has not seen average inflation above 3.5% in 15 years with the exception of 2008 (3.8%). I'm sure there are many sources to back up this data, but google gave me these first: http://www.usinflationcalculator.com/inflation/current-inflation-rates/, http://www.tradingeconomics.com/united-states/inflation-cpi. I realize that if you account for pre-1990 years, the average goes up. However, should those economic conditions which produced massive inflation be considered an anomaly rather than a future expectation?

As stewards of our personal finances and advisers to the readers of this forum, should we account for the risk of depressed inflation rates or even deflation in our calculus regarding whether to pay off or hold on to low interest debt (i.e. mortgages, student loans)?

I'm looking forward to hear what others have to say on this matter.

[nawhite]

I'm not at all worried about inflation and choose to keep low interest debt for 2 reasons:

1. My expected returns in the stock market in the long term - inflation are likely to be greater than my 2.5% student loan and probably my 3.75% mortgage. This is likely regardless of what inflation does as except for post WWII, higher inflation also came with higher stock market returns.

2. My fears about inflation are less than the general public b/c my spending is very low (both absolutely and compared to my income) compared to many people in the US. Inflation is only a negative thing for the portion of your income spent on full priced and non-appreciating assets. My clothes I buy at goodwill for 90% off. My cars I buy used and then drive for 15 years or sell for more than purchase price. A portion of my food I grow. So my total Inflation exposure is VERY low overall.

[beltim]

I don't think anyone would argue that a 30 year mortgage will result in you paying less in real terms – put another way, the comparison is not whether inflation exceeds the interest rate on a mortgage.  A mortgage is not a hedge against inflation, but a house (or really land) is.  Or, if you could pay off the mortgage but choose not to, then the stocks that you buy instead are your hedge against inflation.

As to whether a house, land, or stocks are a better or worse hedge against 2% inflation rather than 4% inflation, I'm not sure.  I know I've seen studies that equities do best under "moderate" infationary conditions, and I'm not sure if that fits 2% or 4% better, or if there's a significant difference. 

[tomsang]

If you plan on staying in your house for the next 30 years or to the term of the loan, you can calculate the value of your loan based on current rates.  I spelled out the steps to show the value of the loan in a post at https://forum.mrmoneymustache.com/investor-alley/paying-off-mortgage-early-how-bad-is-it-for-your-fi-date/ . Financial institutions are required to calculate the asset or liabilities of their loans in a similar fashion.  As a consumer, a loan is primarily an asset, because if the the loan interest rate is higher than market for the most part you can refinance and get a lower rate and reset the loan.  Where a bank if you have a 30 year fixed rate loan can not come back to you and force you to pay a higher rate. So their loans to you are valued at higher or lower than the actual principal owing based on the current interest rates vs. your locked in rate, calculated based on expected actual term vs. ie a 30 year term.

Here is the quote/calculation from that post:     

"US Mortgage Interest rates had the largest increase in 38 years last week.

http://www.fool.com/investing/general/2013/06/27/weekly-mortgage-rates-rise-most-in-38-years.aspx

Those that have a 30 year fixed rate mortgage in the 3.xx increased their networth on the value of their mortgage.  The value of your locked in cheap loan is an asset as long as you keep it to term.  You can calculate the NPV of the loan with your interest rate and the market's interest rate to determine how much you have made.

To calculate the value of your gain,
1)  Calculate or obtain the Principal and Interest on your current mortgage payment
2)  Figure out what the current interest rate a similar loan at current rates.
3)  Go to this website or your favorite NPV website    http://www.pine-grove.com/online-calculators/present-value-annuity-calculator.htm
4)  Enter your monthly P&I payment as calculated or known in step 1:
5)  Enter today's mortgage interest rate as indicated in step two as the annaul discount rate.
6)  Fill out the term and other information and calculate.
7)  Take Present Value as calculated and subtract your current loan balance
8)  The difference is the NPV gain or loss on your loan vs. the current rates. 

IE:  $450,000 30 year fixed at 3.5% locked where interest rates are now at 4.5%, I left it with no payments made for simplicity sakes even though the 3.5% rates were easier to obtain a few months ago.  The value of your cheap loan is :

$450,000 Loan Balance
($397,086) Present value of the the monthly mortgage payments at 4.5%
$52,914 gain

If your PP, stocks or others are down.  Maybe your interest rate hedge(30 year fixed Rate Mortgage) kicked off a gain this week.  This works in reverse as well if interest rates drop, but they have been at historical lows so the downside risk is probably on the lower end of the spectrum.

Don't prepay your mortgage if you have a low 30 year fixed mortgage.  Enjoy the interest rate hedge.

Tom"

[Johnny Aloha]

Agree with nawhite and want to add something else: the financial system and macro-economy in general are so complex and interdependent that I don't think anyone really knows what inflation will look like.

As an example, it was common knowledge and common advice *cough cough* that interest rates were going to rise astronomically in mid-late 2010 when the fed stopped QE1.  At the time, interest rates were around 5-5.25% for a 30yr fixed.

So I tend to think low interest loans will pay off in the long run, and I've loaded up on them as much as possible (~$1.3M in housing loans at 3.25-3.8% 30 yr fixed).

[Nords]

As stewards of our personal finances and advisers to the readers of this forum, should we account for the risk of depressed inflation rates or even deflation in our calculus regarding whether to pay off or hold on to low interest debt (i.e. mortgages, student loans)?

We hold on to our mortgages because (1) retirees can find it difficult to produce the cash flow to qualify for a mortgage, (2) I don't know when we'll ever have interest rates this low again, and (3) we don't invest in bonds.

If interest rates go lower then we'll refinance.  If interest rates go higher then we'll just keep the mortgage.

Our last mortgage payment is currently projected to happen around my 80th birthday.  I hope I last longer than the debt...