Financial Planning 101: Part 11
Housing, Mortgages & Inflation

by Gerald Townsend, Financial Editor
November 2009

The economic events of the past two years have raised the twin specters of severe recession leading to depression and deflation, or government pump-priming and soaring deficits leading to future hyper-inflation. Whew! What’s the best way to die — being shot or stabbed?

Today’s economic news reports reminds me of the old joke about the teenager who flunked a quiz at school. Reluctant to convey this bad news, he first sets his parents up by alluding that something truly horrible had happened. Once they discover that he "only" failed a quiz, they are relieved. Yes, the economic news isn’t rosy — but perhaps not as bad as we feared.

Who will prevail in this battle between deflation and inflation? My money is on inflation. Most economists don’t see any imminent threat from inflation and the markets apparently agree, since interest rates remain at very low levels. In fact, Social Security recipients won’t be getting their normal boost next year, since we have experienced some mild deflation this year.

However, with our national debt climbing to Mount Everest levels and the continual slide in the U.S. dollar, future inflation is a likely prospect and along with that will come higher interest rates.

Investors are already focusing on this, as money has flooded into inflation-sensitive investments such as TIPS (Treasury Inflation Protected Securities), commodities, gold, etc. In addition, homeowners who are currently licking their wounds with the drop in home values can take some solace from the fact that real estate is also a traditional inflation hedge.

If you are currently sitting on an adjustable-rate mortgage (ARM), now is the time to consider refinancing to a fixed rate. During the housing boom 6.5 million homeowners took out low-rate ARMs and 1.5 million of these will soon be resetting. Fortunately, with interest rates falling even further, ARMs may be resetting to a lower, instead of a higher, rate. So, the good news is that the inflation train has not left the station, providing ample time for homeowners and real estate investors to consider their options.

Nationally, the current rate on 15-year fixed mortgages is 4.6% vs. 5.2% on 30-year mortgages. A 5-year ARM is 4.3%, providing little savings compared with a fixed, but with a lot of risk if rates rise.

Of course, the time you plan on being in a home is also a big factor. If you anticipate moving within five years, an ARM is probably fine, but if your time span is longer, the fixed-rate looks much more compelling.

What about 15 years vs. 30 years? I’m usually an advocate for paying debt down as soon as it is practically feasible — particularly if you are headed into retirement. However, a contrary viewpoint is that if interest rates do rise substantially in a few years, holding a long-term fixed mortgage with a comparatively low interest rate is also a hedge against inflation. Presumably the money you save by not paying off the mortgage could be invested in a higher-yielding investment.

Of course, as we have seen over the past two years, things don’t always work out like we think.

Gerald A. Townsend, CPA/PFS, CFP^®, CFA^® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com