Use your mortgage to beat inflation

If you've got a mortgage, it's time to think about inflation.

With UK Government debt now standing at £857.5 billion, it's likely that our government will encourage inflation at some point. How else are they going to clear this great big debt?

Now if you have a mortgage, this will affect you. Some people say that their mortgage will be 'inflated away'. In other words, they'll effectively pay off their mortgage on the cheap. That could happen. And I'll show you how.

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But there's also a great big fly in the ointment. Let's take a look

How the government could pay off its debts

First, how does the government benefit from inflation?

Say you lend the government £100K, by buying a 25-year gilt. Gilts are normally a fixed rate, interest-only loan. If you put £100k into a 25-year gilt, you'll get fixed interest payments from the government (about 4.5% just now) for the next 25 years, and then you'll get your £100k back.

But if inflation has taken off in the meantime, you'll have a rather nasty shock.

Let's say inflation is 10% per year. Every year that big chunk of money you lent to the government will be worth that bit less. And that really adds up.

Over the 25 years, the real value of your investment will have fallen from £100,000 to £9,229. That's a drop of nearly 90%!

So from the point of view of the borrower - in this case the government - inflation is a marvellous thing. Their ongoing interest payments are fixed (so they're gradually decreasing in value too). And at the end of the loan period they only have to pay back 10% of the capital they borrowed. Nice!

That's why many people think our horrifically indebted government will do all it can to encourage inflation.

What does inflation do to mortgages?

But how does this affect your mortgage?

Mortgage borrowers also get the same inflationary benefit. It's not as pronounced, because mortgages normally aren't interest-only loans. With most mortgages you're paying off the capital at the same time.

To get the maximum effect from inflation, an interest-only mortgage would be best. Here all the capital is exposed to this wonderful inflationary erosion.

But here's the key point The interest on the majority of mortgages is floating. That's quite different from gilts, where the interest is fixed.

Even if you do choose a fixed-rate mortgage, it's usually only fixed for two or three years. That means it's much more like a floating rate when you consider the term is usually 25 years.

The problem with floating interest rates

And there's one big problem with having a floating interest rate. It's this: the interest payments will always out-pace inflation. At the moment inflation is around 3%. And Bank of England figures show most mortgage rates are between 3% and 5% - in other words, equal to, or higher than inflation.

I mean, what self-respecting bank would lend at a rate that lost them money in real terms?

When it comes to pricing mortgages (regardless of where the Bank sets base rates), it's inflation that really matters.

Higher inflation simply leads to higher interest on mortgages. This is what makes life difficult for borrowers. As mortgage rates outpace inflation, the interest bill just keeps climbing. This can be very scary. Not only will the mortgage be heading skywards, but so will the rest of their bills.

In this case, inflation may well be whittling away at the capital part of the loan. But it's of little solace if you're struggling to keep up with interest payments. So, how can borrowers protect themselves, or even profit from inflation?

How to protect yourself from inflation

Inflation will be a boon for those with a fixed interest rate. But I'm not talking about a short-term fixed rate. The common two- or three-year fixes aren't going to be that helpful if serious inflation comes back. Once it's out, it can take quite a while to get the inflationary toothpaste back into the tube.

If you think inflation is on its way, then you need to fix your interest rate long. I've just seen a ten-year fix available at 5.2% from Britannia. All the usual terms apply 25% deposit, £999 arrangement fee and early redemption penalties.

Now, I'm not saying we're heading into inflation immediately. I'm just saying that the government may want to encourage it.

The outlook for inflation (and therefore interest rates) is far from predictable. But if inflation does come our way, then a 'long-fix' will be the best bet. And anyone that fixes at 5.2% is going to be sitting very pretty over the next ten years.

This article was written by Bengt Saelensminde and was first published in the free daily investment email The Right Side on 29 March 2010.

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