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Income: The Final Nail in the Coffin For Inflation

Last week we covered how we can use debt to fight inflation, not only by requiring less money to secure possession of an appreciating (at least in the eyes of inflation) asset, but by shrinking the debt that we take out to secure it.  While that shrinkage usually does not make up entirely for the interest payment, it usually will take a rather large chunk out of it, resulting in a real interest rate (interest rate minus inflation rate) of 1-3%.    That combined with the “appreciation” of the asset (the nominal value increasing not because the asset is becoming more valuable, but because the dollar is weakening), leads to a small gain in real terms (after inflation is factored in).

But there is one last thing that you can do that will take your returns from gaining slightly against inflation to shooting it through the roof.

Income.   Income doesn’t just kinda-sorta keep up with inflation like most asset’s value does.  It keeps up with it absolutely.   Have your electricity and water bills stayed constant over say, the last 5 years?  Hell no!  Have restaurant prices?  Get outta town!  Has the price you’ve paid at the gas pump stayed constant?  Girlfriend, please! (OK, I’ll stop now.)

If you find yourself an asset that produces income that keeps pace with inflation, while simultaneously “appreciating” (see above) over time, you’ve got yourself a winner!   You couple that with the power of inflation to shrink debt, and your investment is flying!

For example, say you take a loan at 4% interest.   You put down 25% of the value as a down payment, using the loan for the other 75%.

While your last payment will be the same number as the payment is worth today, but that number of dollars will be worth much, much less by then. If the average rate of inflation over the life of the loan works out to be 3%, you’re going to have paid roughly 1% more than you took out in terms of today’s 2018 dollars.  At 4%, you break even, at 5% you’ll have paid less than the value of the loan and so on.      Ditto for how much your investment has appreciated.  If the value of your asset has gone up 5% in one year, but inflation was 4%, you made real value, if it only went up 3%, you lost it.   Depending on what kind of assets you choose, we’re hovering around breakeven territory.

But now… let’s add income from say, a rental property.  Let’s be conservative and say that it generates 2% of the value of the building after expenses and the mortgage service.   Since you’ve only put 25% down, that’s actually an 8% return cash-on-cash.    And here’s the real beauty…. the value of your rents go up every year with inflation, but the debt payment doesn’t.   That 8%?  That’s year one.  By the end of a 20-30 year loan, your debt payment will be half to one third the size relative to the rents.  Your yearly return on that down payment will be much, much higher.  

You’ve borrowed money from the bank which you’ve paid back at a tiny real interest rate to make a great return on investment.  And if inflation spikes at some point in that 20-30 years because, say, our government has debt payments that are way too large to service any other way, you may even be paying a negative real interest rate.  To make money!

Everybody dance now!

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