concept to understand. To budding income property investors seeking to create financial independence and accustomed to thinking of the idea that debt is bad, it’s critical to shift into a “real” vs “nominal” value frame of mind in order to understand how rising inflation turns a particular kind of debt (your mortgage) into a financial instrument of rising value. Let’s examine a quick three-step process that might be illustrative for anyone struggling with the concept.
Reduce the Scale
Sometimes it’s easier to begin thinking about a new idea on a smaller scale. Rather than pondering how inflation reduces the value of an entire country’s currency, a property investor might instead seek to grasp the idea that it is the prime mover behind the reality of one single dollar losing its purchasing power over time.
A Single Dollar
Now that you’re thinking smaller, let’s introduce a real world example of how rising prices create a less valuable dollar. For an example, let’s say it is January 1, 2013, and we have looked into the future to find out that the annual rate of inflation for the
coming year will be 10 percent. Don’t worry about how we ascertained the information. Extrasensory perception. Time machine. Make something up. The important thing here to hone in on is the inflation rate. Under t
he given conditions, that dollar in your pocket on 1/1/2012 will only be worth .90 cents on 1/1/2013. Why? It’s simple math. When prices inflate by a given rate – in this case 10 percent – the real purchasing power of your dollar bill drops by the same percentage.
Go Out Another Year
By now you should have a better understanding of how a year’s worth of inflation sucks part of the value out of a dollar bill. Now it’s time to broaden the horizon to understand the effect over time. There you are on 1/1/2013 holding a one dollar bill that, once again, in real terms, will only buy .90 cents worth of goods valued on 1/1/2012. Let’s go out another year, to 1/1/2014, and see how things shape up. Assuming another 10 percent inflation rate, and your dollar – which has already been devalued to .90 cents – takes another hit and is reduced to only .81 cents in real buying power.
By that time, most thinking people are beginning to feel a little panicky at the idea that, over two short years, every dollar they own has fallen in real value to .81 cents. While some might scoff and point out that the government’s inflation rate is traditionally only about 2-3 percent, our research indicates the actual number is much higher.
The bottom line is that an inflationary economy reduces the value of money. Logic tells you that you need to find out what is the opposite of money? That’s easy. Debt! Not just any debt, though. Only long-term, fixed-rate debt in the form of a mortgage tied to a piece of income producing property will do the trick. (Top image: Flickr | photosteve101)
The Young Wealth Team