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An Insider's Guide To Home Prices, Profits And Inflation Peter G. Miller - Mortgage Lenders Plus.com Add to Delicious, diggit, reddit, technorati favs

About 75 years ago my grandparents bought a home in what was then a distant and exotic part of New York. Family legend has it that they paid $8,000 for a brick row house in Brooklyn, a property I knew as a child and a home which today has a market value of roughly $800,000.

While the home was sold long ago when my grandfather retired at age 89, it's hard to miss those numbers: $8,000 then, $800,000 now. And yet the story behind the numbers is a little bit more complex.

Inflation & Wealth

The value of a dollar when my grandparents bought -- say in 1930 -- and the value of a dollar today is very different. According to the Bureau of Labor Statistics, $8,000 in 1930 would have buying power equal to $97,000 in 2007.

This huge difference in values is merely a by-product of inflation. With inflation dollars buy less so you need more of them and things seem to be more expensive.

If we subtract $97,000 from $800,000 we can see that the value of my grandparent's house rose by about $703,000. This money represents real wealth because it reflects increased buying power above the rate of inflation.

Imagine if today my grandparent's house was only worth $90,000. That's sure a lot more than $8,000 and it seems like a big profit, but actually it would represent a loss of buying power because $90,000 is less than $97,000. (In fact, real estate values are not guaranteed to go up because of inflation or for any other reason. Family legend has it that the value of my grandparent's property actually sank at one point to $4,000 -- an event which must have been very disconcerting to them.)

Wealth, then, is not just a by-product of big currency numbers, it's a by-product of more buying power. For instance, my wife and I were in Romania this summer. You could purchase goods there with "old" lei. In fact, you could stuff your wallet with bills for 100,000 old lei. And how much were 100,000 old lei worth? About $2.70.

The Bottom Line: When real estate prices go up that's good. When real estate prices increase more than the rate of inflation, that's great and a sign of increased real wealth.

Inflation & Mortgages

We saw with my grandparent's house -- with real estate -- that it's fairly easy to compare purchase prices and current values. We can correct for inflation to see if our real estate investment has paid off in real buying power.

Of course, dollars are just one way to measure the value of property. Homes also have worth in terms of shelter, lifestyle, ego, status and other forms of satisfaction.

Mortgages can be different. Inflation can impact mortgage payments. In fact, inflation in some circumstances can make mortgages relatively cheaper.

Imagine that you financed property with a fixed-rate loan at 6.25 percent -- about today's rate. If you borrow $125,000 at 6.25 percent over 30 years your monthly payment for principal and interest will be $769.65.

Now let's say, just for argument, that inflation this year is 2.5 percent. That means next year your monthly payment will still be $769.65, you'll still pay in cash with $769.65 U.S. dollars but those dollars will have less buying power because of inflation: In this example, $769.65 less 2.5 percent means you're really paying $729.63 so you'll have about $480 a year in additional buying power because you're paying a fixed cost (that $769.65) with cheaper dollars.

When you first borrowed $125,000 such money represented buying power worth a full $125,000. If we skip forward 10 years -- and if the rate of inflation has been 2.5 percent annually -- that means you've paid interest with cheaper dollars each year.

Now imagine that you decide to sell the property. After 10 years of ownership and with amortization the original debt has been reduced to $105,297.

You've got $105,297 to pay but you're not going to pay with those older and more valuable dollars from 10 years ago. You're going to pay with dollars that have less value after a decade. In effect, you can pay off the loan balance with the equivalent of $81,745 in old dollars.

Just like you, lenders are aware of inflation. To maintain the buying power of the interest income they receive, virtually all lenders offer adjustable-rate mortgages. In essence, with ARMs lenders trade increased inflation protection for them in exchange more liberal qualification standards and lower "start" rates for borrowers.

Can an ARM ever be a hedge against inflation for borrowers? Yes -- if the rate of inflation grows more quickly than interest levels. However inflation is not the only issue to consider with ARMs. If adjustable rate mortgages require higher payments then you have to have the cash to meet such monthly costs. Hopefully borrower income has also increased at or above the rate of inflation.

Inflation, of course, is not guaranteed. Currency values deflate and then dollars will buy more rather than less. But while deflation can occur, inflation is the more common event.

To find out which loan option is best for you, consider your personal financial situation and preferences and be sure to check with several lenders.