Understanding Variable Inflation Rates In An Inflationary Environment

By Michael Iakovou and Matthew McCarthy

If you’re in the market to purchase a home or another type of real property, you likely know that mortgage

Inflation is the sometimes gradual increase of prices on goods and services. When price levels rise, each unit of currency buys fewer goods and services. Periods of inflation disrupt the economy’s pricing system, forcing spenders to undertake less-than-optimal spending practices, saving management and investment decisions. Economic players take measures to protect themselves against detrimental effects by diverting resources away from more productive activities. The rationale is that inefficient damages diminish earnings, slow economic progress and lower living standards. The overarching goal of these players is to keep inflation low enough to stabilize the economy and promote productivity of utilized resources. However, as the last year has demonstrated, there are forces outside of human control that can destabilize inflation.  

In addition to economic destabilization, inflation periods drastically affect real estate investments. Performances in a rising interest rate environment look positive at a distance; income-generating real property has historically shown a greater ability to grow net income during inflation periods than securities and other assets have. However, a general positivity in performance does not mean all facets of real estate investments are safe. This general positivity leads to an increased cost of borrowing debt that impacts real estate investors right where it hurts: their pockets.   

To make sure financial institutions retain a modicum of control—and avoid any delinquent accounts—banks will charge a higher interest rate and offer fewer loans. This leaves investors scrambling to apply for loans that might not be suitable for every investment. This article serves as an outline of the affects inflation plays on variable inflation rates and a means to approach certain loans to combat debt strategically.     

HELOC Loans 

When the value of a home is more than what is owed on a mortgage, the difference is considered to be equitable. A home equity line of credit—HELOC for short—is a type of home equity loan that allows equity to be used as collateral to borrow money. This loan is often used to fund home improvement projects or other major expenses that gives homeowners wiggle-room and peace of mind. HELOCs function similarly to credit cards; the bank issues a maximum amount of borrowing power—a line of credit—made available to be taken out and paid back until the draw period ends. Interest is added solely to borrowed funds, not whatever the maximum amount is at a current time.  

HELOC rates are set based on the lender’s cost to borrow money; this cost is affected by federal changes among a myriad of factors, such as the consumer trend to turn to home equity products as a means to preserve and maintain spending. Interest rates for HELOCs are expected to climb through the end of 2022. Many HELOCs base variable rates on the prime rate, which tends to track increases in short-term interest rates by the Federal Reserve.   

The Federal Reserve is expected to keep raising the benchmark to combat current inflation rates. The problem is that this rise in the benchmark will trigger consumers to turn to such HELOCs for purposes other than home improvement, disregarding cash-out refinances. Prior to this period, cash-outs were extremely popular due to record low mortgage rates. This led to an increase in home prices. However, since the start of 2022, mortgage rates have risen more than two percentage points and has made consumers weary to take on significantly worse mortgage rates in order to preserve a bit of cash. 

Like a mortgage, HELOCs are secured against real property. If the loan is not paid back in full, the bank can reclaim the home through foreclosure. Because of this risk, it is always important to err on the side of caution; if borrowing a HELOC loan is not a priority or necessity, it is best to seek an alternative, such as a cash-out refinance. While home equity products have their merits, they are not one-size-fits-all. HELOCs are great for home renovation projects but are not ill advised as a means to acquire fast-cash for vacations or investments in the stock market.  

For those who have a firm knowledge of the risks of borrowing HELOCs and a plan to pay the loaned money back in full, HELOCs are great ways to help lower interest rates than other types of borrowing.  

Credit Card Debt 

Credit card debt surged in the United States from April 2022 through June 2022. The national credit card debt has jumped by roughly $100 billion—or 13%–which is the largest percentage increase in more than twenty years. Americans began borrowing these billions of dollars to continue spending despite growing inflation trends. The impact of inflation on credit card holders leads to difficulties for consumers to stay within budget; consumers turn to credit cards when earnings to not go as far as they did in the past. 

Credit card issuers typically charge higher interest rates when balances are not fully paid off. The Federal Reserve attributes this binge in credit card usage to inflation trends as prices have risen at the fastest pace in more than four decades. This period of high inflation has increased expenses to carry a credit card balance because the Federal Reserve continuously—and aggressively—raises borrowing costs. At the current benchmark rate, there is an expected rise in percentage by the end of the third quarter. 

Mortgages 

As inflation rates increase, mortgage rates rise; the demand for mortgage-backed bonds decreases as mortgage-backed securities fall. This fluctuation results in higher interest rates of all types of mortgages. In this period of high inflation, mortgage loans are more expensive due to these higher interest rates, leading to higher monthly home loan payments.  

Currently, the Consumer Price Index—CPI—rests at 9.1%. Put another way, if a mortgage rate rests at roughly a 5% interest rate, the mortgage rate is -4.1%. Despite the rise of mortgages amid increasing inflation rates, the real mortgage rate is typically a negative number. This negative real rate on mortgages is unprecedented performance that has not occurred in forty years. 

The significance of this decrease demonstrates a myriad of outside forces that play a role in the performance of interest rates in a mortgage loan. Typically, inflation leads to higher mortgage interest rates because of the devaluation in the U.S. dollar. While inflation does not directly affect mortgage rates, it can indirectly cause mortgage rates to rise.  

Conclusion 

Inflation can have a negative impact on fixed-income assets when it results in higher interest rates. Prices change at different paces. Some, such as the prices of traded commodities, change every day whereas others, such as wages established by contracts, take longer to adjust. In an inflationary environment, unevenly rising prices inevitably reduce the purchasing power of some consumers. This erosion of real income is the single biggest cost of inflation. 

For more information on the current trends in the economy and how those trends may affect your business, contact KI Legal. At KI Legal, the skilled attorneys of our Real Estate Finance practice represent a variety of commercial, residential and private lenders. This knowledge and experience can assist you with all your financing needs and concerns. Visit us at https://kilegal.com/ or contact us at (646) 766-8308. 

References: 

J. Reed, Rising Inflation Keeps Pushing Home Equity and HELOC Rates Up, NextAdvisor, Jul. 14, 2022. https://time.com/nextadvisor/loans/home-equity/average-heloc-home-equity-loan-rates-july-14-2022/ 

J. Peiser, Credit card debt surges as inflation pushes Americans to borrow more, The Washington Post, Aug. 2, 2022. https://www.washingtonpost.com/business/2022/08/02/credit-card-debt-inflation/ 

J. Dickler, Use of credit cards, personal loans surges, but ‘it’s not a red flag,’ expert says, CNBC, Aug. 5, 2022. https://www.cnbc.com/2022/08/05/credit-card-usage-surges-amid-record-inflation.html 

D. Rafter, What Does Inflation Do To Mortgage Rates? A Guide For Uncertain Times, Rocker Mortgage, Aug. 1, 2022. https://www.rocketmortgage.com/learn/inflation-and-mortgage-rates 

M. Black, T. Perkins-Southam, Credit Card Spending Ramps Up As Inflation Soars: How To Fight Inflation With Credit Cards, Forbes Advisor, Jul. 20, 2022. https://www.forbes.com/advisor/credit-cards/inflation-credit-cards/ 

A. Durante, C. Kallen, H. Li, W. W. McBride, G. Watson, Details & Analysis of the Senate Inflation Reduction Act Tax Provisions, The Tax Foundation, Aug. 10, 2022. https://taxfoundation.org/inflation-reduction-act/ 

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