Likes being in debt. However, it is important to understand the relationship between debt and inflation. Inflation has a profound impact on the cost-effectiveness of borrowing money. In fact, there are cases where it came be cheaper to borrow money and pay interest than to pay off a loan. This obviously runs counter to what a lot of people promoting the debt-free movement will tell you. That’s why it’s important to understand the numbers for yourself.
Right now mortgages are at historically low rates. It’s unlikely you’ll ever see rates this low again within your lifetime. You can get a home mortgage for around 4.5%. That is an interest rate that is locked in for the 30 year life of your loan. On the other hand inflation has traditionally been around 6%. What is inflation? Inflation refers to the gradual erosion of your purchasing power. At 6% per year it means that something that cost one dollar 365 days ago will cost you $1.06 today. Obviously inflation does not occur as a smooth increase. Instead he jumps up and down but historically the rate averages out to 6%.
So that means that a house that costs $100,000 today will cost $106,000 in one year. 30 years from now the same house should cost $280,000. The interest over 30 years on a $100,000 home will be around $80,000. So in 30 years you will paid $180,000 for home that is worth $280,000. Now don’t get too excited here. That $280,000 will only by as much as $100,000 would 30 years ago.
Of course the house will still be worth $280,000 even if you paid for in cash up front. Let’s say you did that. You buy a home for $100,000 and pay the entire price upfront in cash. Let’s say your neighbor does the exact same thing. He buys a $100,000 home next door but instead of putting the cash up front he takes out a 30 year fixed rate mortgage at 4.5%. He then puts his $100,000 into an index fund. An index fund simply follows the stock market. It is basically a mutual fund that will perform the same as the S&P 500 index.
Over the next 30 years your neighbor will pay $80,000 more for his home in interest. You don’t have to pay that interest because you pay for your home in cash. At the end of 30 years you both have homes that are worth $280,000. Your neighbor has paid an additional $80,000 in interest, but he has also let the $100,000 growth for the last 30 years.
Traditionally the stock market has performed at 11% over long periods of time. For the sake of example let’s look at the years from 1980 to 2010. The average rate of return was 12.93%. That means that every dollar invested in 1980 $28.31 so your neighbors $100,000 is now worth $2.8 million. You both started at the same place and with the same amount of cash. However at the end of 30 years your neighbor’s decision to pay an extra $80,000 in interest doesn’t look like such a bad idea.
If you’ve been following this so far you may wonder what is happening here. The answer is very simple. Right now interest rates are extremely low. They are unusually low because the government is driving the interest rates down to keep the economy going. This is a temporary situation and will not last forever you however you can take advantage of the situation by using historical averages of inflation and the stock market to allow yourself to come out ahead. In the long run you will be paying for what the government is doing through taxes and possibly a higher rate of inflation. However, you will be paying for this regardless of whether or not you take out a loan yourself.
