Expensive Eggs and Rising Gas Prices: How Does Inflation Help Me Pay My Mortgage?

Inflation – a general rise in the price of all the things we buy – is a constant topic in the news, and no wonder: when the price of food, fuel, housing, and other things we purchase goes up, it gets harder to buy the things we want and need. And if you have debt – because of a mortgage, car loan, student loan, credit card debt, or some other reason – the pinch of rising prices may feel especially painful. But something counterintuitive, yet long known by economists, is that under certain circumstances inflation can actually help people in debt.

The trick to understanding how inflation can help people with debt is to understand that there are different kinds of inflationary episodes. Sometimes when prices go up, people’s incomes go up in roughly the same proportion. Let’s call that income-price inflation. Other times, prices go up, but people’s incomes do not keep up.  Let’s call that simple-price inflation.

Consider Simple-price Inflation

Imagine there is some shock to the economy – a pandemic, a war, a loss of access to crude oil or some other critical resource, or even a widespread labor strike. At least in the short term, these situations can make society poorer: prices go up as goods and services become harder to produce and acquire, and people aren’t able to buy as much. Simple-price inflation does not help debtors pay off their debt; in fact, as people have to spend more on eggs, gas, and other goods and services, they will have less money left over to pay off their debt.

Now Consider Income-price Inflation

As an example, imagine if one day everyone woke up to find that the amount of money they had exactly doubled. If you previously had $100 in your wallet or in your bank account, you wake up to find $200 instead. After an initial period of confusion, sellers would realize that they can now charge twice as much, and workers would realize they can demand that their wages double, because every individual and company would have twice as much money as they did before, even though the goods and services available to be bought and sold wouldn’t have changed at all. Once the process worked itself out, the doubling of money ultimately wouldn’t change much. It wouldn’t make anyone richer either: since everyone would have their income doubled and would have to pay doubled prices, everyone would still be able to afford exactly the same bundles of goods and services that they could previously afford.

There are exceptions, though. People who are in debt would be made better off by a doubling of incomes and prices, so long as their amount of debt, in dollars, doesn’t change. For example, suppose you have a fixed mortgage payment – which is a kind of debt payment – that is $2,000 per month, and your salary is $5,000 per month.  This means that, after your mortgage payment, you have $3,000 left over to spend on everything else.  Now suppose your monthly salary doubled to $10,000, but your mortgage payment doesn’t change. You now have $8,000 left over after your mortgage payment, which is more than the $6,000 (two times $3,000) needed to buy the same bundle of goods and services you were buying before! Even if the prices of everything else you buy doubled along with your salary, you would still have been made significantly better off by this inflationary episode.

People who are owed debt are made worse off by a doubling of prices if the dollar amount that they are owed doesn’t change. This is because whatever dollar amount they are owed, those dollars can be used to purchase half as much after the doubling as it did before the doubling.

In real life, it is unlikely that we’ll wake up one day to find that all our money has doubled. But the Federal Reserve really does increase the money supply on a regular basis, for reasons we won’t go into here. To the extent that these money supply increases cause both prices and incomes to go up, they allow some debtors, specifically those with fixed payment schedules and interest rates, to have more money left over to spend on things beside paying off their debt.

But be warned! Inflation only helps debtors if it was unexpected at the time when their debt contracts were signed. Imagine you are about to sign a 30-year fixed mortgage that will obligate you to pay some dollar-amount monthly for the next 30 years. If you know that there will be significant inflation over the next thirty years, and you know that wages and incomes will rise along with prices during these inflationary episodes, then you realize that your fixed mortgage payment will become a smaller and smaller fraction of your income as the years go by.  But unfortunately, your lender probably has access to the same economic forecasts as you do. Since lenders are hurt by inflation in much the same way that debtors are helped by it, the expected inflation will cause the lender to want to charge a higher interest rate and make you pay a higher monthly amount. That is why, in general, inflation only helps a debtor if it is greater than what was expected at the time the debt was entered into.

This discussion so far suggests that people in debt are in some ways just like everyone else, better off when their incomes go up, and worse off if prices go up without an accompanying rise in their incomes.[1] What is unique to debtors is that when prices and incomes go up by the same proportion, that makes the debtors better off. Remember this assumes that the dollar-amount of debt doesn’t adjust along with inflation, and that the changes in prices or income were unexpected at the time debt contracts were entered into.

To sum up, the manner in which inflation affects people in debt depends on the type of inflationary episode and the specific details of their situation. When prices and incomes rise in roughly the same proportion, debtors are better off because their debts shrink in proportion to their incomes. But when prices rise without an accompanying rise in income, this usually means that most people are generally poorer.

 

 

[1] There is an important case where inflation helps people in debt, even if their wages or other incomes don’t rise as well: the case of someone with mortgage debt who plans to downsize. To keep numbers simple, imagine you own a million dollar home with $200,000 of debt (meaning you have $800,000 of equity in the home.) You plan on selling your house and using that $800,000 to buy an $800,000 house without taking out a new mortgage (ignoring transition costs). Now imagine that before you do any selling or buying, an episode of inflation causes the value of all homes to double. You would now be selling a two-million dollar house with $1,800,000 of equity (because your debt is still $200,000 and two million minus $200,000 equals $1,800,000). The value of the house you are buying has doubled to $1,600,000, which you can easily afford with $200,000 left over ($1,800,000 – $1,600,000 = $200,000)!  So this is an important way that a person in debt might be made better off by a rise in prices even if their wages or other income didn’t go up.

 

Mark Robinson, Ph.D., Director | [email protected]

Mark Robinson is a director at ESI. He received his Ph.D. in economics from Temple University in 2023. While at Temple, he taught courses on the American economy and issues in public policy. Dr. Robinson’s research specialties included labor economics, environmental economics, and macroeconomics. His work has examined reasons for the decline of the labor share in the United States, how household debt affects workers’ bargaining power with employers, the relationship between how much we work and how much we pollute, and how the amount we work affects the amount we drive.

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