The Effects of Inflation...
How much interest am I paying anyway?

Have you ever looked at a spreadsheet that showed you the whole amount of money paid out on a thirty-year loan by the end of the term? A $300,000 loan over thirty years at 6% is $347,515 interest on top of the $300,000 principal paid. Though most loans are not kept for a full thirty-year term, it’s enough to scare some people out of ever buying real estate. But considering the inflation factor, the use of other people’s money can be a bargain.

Inflation Is Our Friend   My parents thought real hard before buying their first home. They were worried sick wondering if they were really going to be able to make that mortgage payment of $328 every month. I laughed when I heard that story because I didn’t understand the value of $328 ‘back in the day’. What happened was that over time, inflation ate away at the value of the dollar. Each year that payment got a little easier, thanks to inflation. In those days, fixed rate loans were their only option. So while their payment never changed, the salaries continued to rise with inflation. Little by little, making that payment got easier and became a smaller percentage of their total expenses.

Nominal vs. Real Interest Rate The interest rate charged is called the “Nominal Rate” The interest rate minus the inflation rate is what economists call the “Real Interest Rate”. The Federal Reserve Bank won’t disclose their actual inflation target. They’ll only say “around two percent per year”. But in actuality, it has been running over 2.7%. There are several different indices used to calculate inflation. The Core Consumer Price Index (or CPI, which excludes food and energy) is about 2.3%. The Producer Price Index is running 4.9% and will trickle into the CPI raising it too. Import prices inflation is at 7.1% due mostly to the weakening dollar. Many economists believe that on the surface, the feds are eager to maintain a very modest inflation rate, but truly want higher inflation to reduce the trade deficit and budget deficit. The Federal Reserve Bank helps regulate inflation by setting and adjusting the Federal Funds Rate interest rate.

Appreciation Someone once told me “If you’re renting, it’s called inflation. If you’re a property owner, it’s called appreciation”. And since appreciation usually stays ahead of inflation, real estate is a favorite long-term investment vehicle for many successful investors. We talk about investment property in another article.

How can I minimize the interest I pay?

• Make an extra payment every year or pay extra principal each month. By paying an extra $150 per month, the $300,000 loan above is paid off in 24.5 years, with a savings of almost $74,000 of interest. Or if you paid $300 per month extra, the payoff would be 21 years, with nearly $120,000 of interest savings.
   
• If your loan servicer offers it, consider a bi-weekly or semi-monthly mortgage payment option. By paying half-payments every two weeks, you cut down interest accumulated and also make two extra payments each year.
   
• Lower, and/or buy down the rate with a refinance. Most loans are paid off through a re-finance long before the 30-year maturity date. But if you’ve decided this is your last loan on a particular property, and have a goal to pay it off early, you should pencil out different financing scenarios with a mortgage advisor. Paying points up front can often be a benefit over a no-cost refinance if it means you obtain a better rate. A lower rate equals less interest paid. And if you make the same payment amount, but apply more of it to the principal, you can accelerate your payoff substantially.
   
• Consider a fifteen-year loan. The shorter the loan term, the lower the rate. If you have the cashflow, and can consistently make the higher payments, your loan will be paid off in... you guessed it – fifteen years!

Each scenario needs to be viewed in light of your specific situation and goals. It’s important to look at competing investment vehicles when choosing where to put your money. In other words, you have to look at what rate of return would you get on money if placed in a different type of investment, compared to paying down a loan early. If you would otherwise spend the money on living large and consuming more, paying the loan down is the obvious choice. You consider it a forced savings account.

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