THE CAUSE OF INFLATION & WHY IT’S A GOOD THING.
You may think inflation is bad. Being able to buy less with your money doesn’t sound that great after all.
But inflation can actually work to your benefit, if you are a property investor.
WHAT IS INFLATION?
Inflation is when money loses value over time. This is most noticeable when you look at the cost of goods and services. It may have cost you $1.50 to buy a packet of chips when you were a kid. Now, the same packet of chips is probably worth around $4.
This is because money is worth less – in other words, you have to spend more of it to get the same amount of value.
DEBT DRIVES THE ECONOMY.
Inflation is managed by the central bank of an economy. The Reserve Bank of Australia aims to keep inflation at around two to three per cent each year.
By lowering or raising interest rates.
If interest rates are low, this means more people can afford to borrow money. With borrowed money, people can spend more. One person’s spending is another person’s income. This means others can then borrow more and spend more and so on.
All this spending does wonders for the economy. When demand for goods and services becomes greater than supply, the price of things tends to go up. The buying power of the dollar decreases.
But if things get too expensive, and wages aren’t going up in line with this, it becomes too difficult for people to spend their money in the economy and make debt repayments.
If the reserve bank raises interest rates, less people are able to borrow money. Existing borrowers are hit with higher repayments, and spending slows down. This helps to stop inflation growing too rapidly.
PRINTING OUR MONEY.
The other thing about inflation is that we operate under a fiat currency. This means our money is only worth something because believe it.
It is not backed by gold or any other commodity that can be useful to us in a practical way.
When the debt burden of an economy gets out of hand and rates are low, the economy must undergo a process of deleveraging.
People struggle to pay back debt. People struggle to spend. Companies go bust and individuals lose their jobs.
The government becomes squeezed because less people are paying tax and more people are in need of welfare.
One solution to cope with this is for the Reserve Bank to print more money.
But, if they print too much, this could lead to hyperinflation.
HOW TO MAKE THE MOST OUT OF INFLATION.
Let’s look at the hypothetical in the video above.
Sarah has $100,000 in savings as a 30-year-old. She keeps it buried in the backyard for 10 years.
Her twin sister, Louise, also has $100,000 in savings.
However, instead of burying it, she splits her money into two 20 per cent deposits of $50,000, including closing costs of $20,000. She buys two houses in Mount Druitt for $200,000, leaving her with two mortgages of $160,000.
Fast forward 10 years and Louise has $300,000 debt and has $1 million worth of assets.
Which sister is better off financially?
Even if the property market remained constant across 50 years and prices only went up in line with inflation, Louise would end up with far more money than Sarah, as her money is still depreciating in the backyard.
She also earned a rental income that was in line with inflation for 10 years.
STRIKING THE RIGHT BALANCE IN LEVERAGING.
Those who are either under or over leveraged will suffer in an inflated economy. Those who have the right balance of debt and assets will be the ones who will make the most money.
Have you grown wealth through inflation? Please share your experiences in the comments section below.