Dashing Debt: The Real Interest Rate
September 30, 2022
Inflation data for August, from the Consumer Price Index (CPI), indicates an increase to 8.3% annual inflation.
Nominal interest rates are determined based on how much, in addition to a loan’s principle, is received.
Real interest rates also take into account inflation’s toll on interest.
Mortgage rates, which hit lows in the two-percent range last year, have increased significantly but still sit below inflation.
The term “debt” is associated with fiscal irresponsibility and poor financial decision-making, but what if that is not always the case? Matt Schulz of LendingTree points out Americans have $887 billion in credit card debt. This type of debt can be detrimental to one’s finances especially considering the high-interest rates. On the other hand, fixed-rate mortgages, or home loans, locked in at low rates look favorable today. In essence, assuming a low, fixed interest rate, the larger the debt one has on their house at the moment, the more they are benefiting from inflation.
One must first examine interest rates to understand how beneficial debt can be. The interest rate is the percentage charged annually to borrow money. Find the nominal interest rate by dividing the amount in interest by the amount of the loan. For instance, eight dollars in interest divided by a $100 loan comes to an eight percent nominal interest rate. Nominal interest rates matter, but the real interest rate is imperative. To calculate the real interest rate, one must subtract the inflation rate from the nominal interest rate. Assuming inflation is at five percent when the $100 loan is issued, one would calculate eight percent minus five percent, coming to a real interest rate of three percent. Inflation measures the erosion of purchasing power, meaning items will cost more at the end of the loan than at origination. Take into account inflation and look at real interest rates.
How do real interest rates explain why having a low fixed-rate mortgage is fantastic right now? Well, in 2021, Freddie Mac reported a 2.65% average fixed 30-year (nominal) interest rate. Also, the Consumer Price Index clocks inflation at 8.3%. Using these figures comes to a negative real interest rate of around 5.65%. A negative real interest rate is great for borrowers. It is as if one borrowed $100 in purchasing power and is only required to return $95 in purchasing power at the end of the term.
While the opportunity to take out a sub-three percent mortgage appears to be over, even at current rates, considering inflation, the situation is not so grim. Bankrate finds the national 30-year fixed rate averages 6.08%, which is still below inflation levels. Even one who takes a loan out at these rates will be paying a negative real interest rate, at least for as long as inflation stays high.
With interest rates, one should differentiate between nominal and real interest rates. Furthermore, due to today’s inflationary environment, low-interest debt is not a horrible thing to have in one’s finances. Why inflation levels will likely not stay this high forever, as long as they do, fixed-rate mortgage debt looks quite enticing.