Inflation and hyperinflation are concerns on the minds of the economists in the United States. With the amount of money that is being pumped into our financial system it is inevitable that prices will begin to rise at some point in the future. Many investors believe that real estate makes an excellent hedge against inflation. Does this theory hold up?
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What is an Inflation Hedge?
If prices of items you purchase are rising, inflation is occurring. To protect against these rising prices and keep your spending power the same you either need to earn more income or hold assets that do not lose value in the face of rising prices.
How Does Real Estate Protect Against Inflation?
Real estate is not a perfect hedge against inflation, unlike Treasury Inflation-Protected Securities, which provide a return in line with inflation. However, compared to other investments real estate provides a good enough inflation hedge. Let’s look at how your home can protect you from inflation.
Fixed Payments Protect You
When you buy a home with a fixed-rate mortgage you are using leverage to purchase an asset you cannot (or don’t want to) pay cash for. The bank let’s you buy an asset while only having to pay 20% of the value of the asset upfront. The remaining 80% is provided by the bank as a home loan, which you have to make consistent payments over the life of the mortgage for this privilege.
The key to your mortgage providing inflation protection is the fixed mortgage payment. If you bought a home with a 4.5% 30-year fixed-rate mortgage today, your payment is the same for the 360 payments you make over the 30 years. You don’t pay less at the beginning and more toward the end of the mortgage. If your payment is $800 today, it will be $800 for your last payment — assuming a simple 3% inflation, your mortgage payment 30 years from now will be the equivalent of $340 in today’s dollars.
Here is an illustration of how the burden of $800 monthly payment reduces over 30 years:
The fixed nature of your payments means that your income increase over many years, you are effectively paying less for your house because your mortgage payments stay the same. Over time your home will actually become more affordable.
Home Values Rise Over Time
Historically real estate value appreciates at roughly the same rate as inflation. This means that your house is protected against the devaluing effect of inflation over the course of your homeownership. Of course, this is just the average. The value of your home will be affected by the condition of your house, economic condition, and your local market condition.
Overall, if you stay in your house for a long time, your house is likely to help you protect your wealth.
The Bottom Line
Obviously, this is not a ticket for you to jump into real estate without doing your due diligence. First and foremost, you have to make sure that owning a home is what you want to do and that you can afford your mortgage payments. Also, this only works well if you are planning to stay in your home for more than a decade; otherwise, renting might be a financially smarter decision.
If owning a house fits well into your financial picture, this is perhaps the best time to buy a home due to the recent housing market correction and historically low mortgage interest rate.
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.