Is Debt a Good Inflation Hedge?
A popular argument among risk-tolerant investors and entrepreneurs is the idea that debt is a good way to hedge against inflation.
Some, including Mike Dillard who is one of my business heroes, argue that if you know inflation is going to be about 5%, and you can buy a house at a 4.5% mortgage, you should go ahead and do it because inflation is actually higher than the interest — you’re essentially getting a free house over time. Or so the theory goes.
While I agree with the math, I reject the idea of using debt as an anti-inflation investment simply because it’s not necessary and it’s incredibly, incredibly risky. Before we look into why I reject the theory, let’s take a more detailed look into how inflation makes debt less of a big deal.
How Inflation Actually Destroys Debt
One of the most basic inflation facts is the notion that inflation destroys debt. The US government realized this nearly a century ago, and began creating inflation in order to go more and more in debt.
This isn’t a conspiracy at all — even government officials talk about “monetizing the debt” in which they essentially create new money to pay off debts both to directly pay the debts off as well as indirectly make currency — and their debts — a smaller real amount. It’s clever.
It works because of simple math. Let’s look at an extreme and unrealistic example to see how inflation eats debt and then look at a more realistic approach that plenty of people I personally know are using right now with their investments
Let’s assume we’re in the middle of hyperinflation. Your currency is losing about 20% of its value every year. You’ve decided that you need to buy a new car, and are looking at a beautiful $50,000 sports car.
You have two options. You can pay for the car in cash, or you can get a 6% interest loan for 3 years.
Some think the best choice here is to take the debt, because after just three years, the inflation is going to turn 50k into roughly 25k. Ouch. Getting the loan can give you an overall discount of something like 30% on your car.
Paying tomorrow’s prices for stuff today is a fantastic decision if the value of money is going to get less and less powerful — it’s essentially getting a massive discount.
Let’s look at a more realistic scenario that plenty of investors are using right now.
People are pretty convinced that inflation is about to increase and hit the 5-15% range over the next 5 years or so. It’s possible to get a relatively cheap 4.5% interest mortgage right now. Some connect the dots and try to make money from this apparent opportunity.
For example, I know some investors who are buying rental properties with cheap debt, because after everything is said and done, they think inflation is going to essentially give them a free house at the expense of the banks.
It’s an interesting idea. If you pull it off correctly, you can end up owning a collection of essentially free houses — millions of dollars in property… if only life consistently worked that way. It doesn’t.
Why This is a Horribly Stupid Idea
Unfortunately, the above scenarios are horrible ideas, because things don’t always work the way we want them to work.
Here are a few factors that the above investors most likely don’t understand or have ignored:
Inflation Isn’t Uniform. If there was just one thing you learned from this entire course on inflation, it should be this: Inflation isn’t uniform.
Just because one market’s prices increase doesn’t mean all market’s prices increase.
Sometimes inflation will hit some sectors harder than others — some sectors will see a deflation while others see inflation.
For example, when it comes to housing prices, they’re currently dropping in value while other markets like gold are going through the roof.
While over time this might even out on some level, it doesn’t skip the fact that this is a giant, giant increase in risk. If you happen to have your investments in a local housing market and it tanks, the overall national inflation rate couldn’t matter less — you’re screwed. You played with fire and got burned.
Lack of Income Inflation. Just because the price of stuff increases doesn’t mean your wages will increase as well.
If suddenly banks are only getting 4% returns and a 25% inflation rate is making their investments completely worthless, do you honestly think the government is going to side with entrepreneurs and investors over the banks? Absolutely not. Banks might be given a special ability to change interest rates in ignorance of the previously agreed upon contracts.
If someone’s going to get screwed, it’s going to be you. Always assume that — it allows you to make much more thoughtful and safe investments.
Debt is Pointlessly Risky. Debt is almost always a bad idea. Forget the macro-economy — if you lose your job, having more payments is always bad, even if they’re supposedly going to pay for themselves.
If the economy gets worse, your chances of making money either from a job or from investments tanks majorly, meaning that adding extra risk on top of this simply doesn’t make sense.
Going into debt because you think the economy is going off a cliff is like dousing yourself in gasoline because you think your house is on fire. It’s just complete insanity.
Instead, the best inflation hedge is a no-debt portfolio that involves gold, silver, energy investments, farmland, and your own home. That’s also a great “anything” hedge. Good financial decisions work in every economic climate.