I wanna talk about how inflation affects the borrower.
So we're back to a spreadsheet.
This is the spreadsheet that I used to create the guess and check
but I've added three more columns.
The first column is for the house price
Which will go up with the general rate of inflation
and the next column is the borrower's equity.
Which is the house price minus the unpaid balance.
And then we have the borrower's payment income ratio.
I assume the borrower has $30,000 of income
and that the income will go up with inflation
So right now I have inflation that parameter set to 0.
And as a result this isn't terribly interesting.
The house price just stays the same
and the payment income ratio stays just the same.
And the equity, the borrowers equity builds up very slowly.
Notice after 10 years the equity is only $17,000
Ok now I'm going to change the inflation rate to 2%
Lets watch what happens.
Particularly the borrowers equity which was
after 10 years was $17,000 without inflation
is now $36,000
so the just the 2% inflation rate
more than doubles the equity build up for the borrower.
So they really build up a lot of equity
and you noticed that their payment income ratio
If assuming that their income
goes up with inflation steadily declines.
So at the start it's 20% of their income
by the 12th year it's down 15% of their income.
So that you get a
For the borrower
inflation appears to be a good thing
However, you got to be careful about that because what we've been
assuming is that the nominal interest rate
is constant while the inflation rate went up.
Suppose we keep the real interest rate constant.
That is the difference between the nominal interest rate and inflation.
So lets start with a 2% inflation rate, 5% interest rate which is a
3% real interest rate. Lets keep a 3% real interest rate
but raise the inflation rate to 4%.
So that means the nominal interest rate will go to 7
And the inflation rate will be 4.
Okay
What happens there is that the borrower equity
builds up even faster.
So with the higher nominal interest rate
The borrower now has 56,000 in equity.
Whereas there were only they only had 36,000
with 2% inflation and we had 0% inflation they only had 17,000.
So this is a big jump in the borrower's equity
and the payment income ratio which was 20% before to start with
is now 24 % it still drops off dramatically
down to 15% by year 12
but it starts out very high
and that's because with the higher interest rate
the monthly payment is higher.
And it takes awhile for the borrower's income to catch up.
So that's something to think about the effect of inflation
for the borrower.
Basically the key points to remember
are that as the nominal interest rate
Sorry, as the inflation goes up
keeping the nominal interest rate constant
It's unambiguously better for the borrower.
The borrower gets more equity and a nice drop in the
payment income ratio.
If when inflation goes up the real interest rate remains constant
so that the nominal interest rate rises its not quite as good
for a first time borrower.
coming to buy a home because that payment income ratio
goes up
And I'll talk about it that more in a subsequent talk.