Categories
Investing

Why Deflation is Good for Bond Investors

Deflation is good for lenders. Inflation is good for borrowers. Why? It all has to do with the future real value of money.

If a dollar in the future is worth more than a dollar today, it becomes increasingly expensive (in real terms) to service debt and increasingly beneficial to receive coupon payments. When dollars become more valuable, purchasing power rises. This means you can buy more stuff with the same amount of money. (In reality, most of the time future dollars are worth less than today’s dollars due to inflation.)

Here’s an example: if I’ve lent out $100,000 in exchange for $10,000 annual payment plus principal at maturity, I would prefer those future payments to have greater real value. While I will receive $10,000 in all situations, the value of that $10,000 is affected by prevailing price trends. A deflationary price environment erodes the prices of goods and services, thereby making future dollars more valuable, benefiting lenders.

The following chart illustrates this concept:

If deflation is good for lenders, why wouldn’t banks seek to create a deflationary environment by reducing money supply? While deflation might benefit a single lender, widespread deflation would actually hurt lenders due to greater loan defaults. A deflationary spiral lowers prices, causing companies to cut production and reduce wages. This reduces aggregate demand, further pushing down prices. Asset prices decline are liquidated to cover rising cost of real debt, with many organizations forced into bankruptcy as asset values fall below liabilities.

Beyond this, our entire credit based economy is predicated on growth, of which inflation is a component. A combination of real growth (productivity growth + population growth) and inflation is required to cover aggregate interest costs within an economy. Since real growth is hard to create, inflation is the grease that keeps the economic wheels turning.

Categories
Real Estate Wealth

What You Must Know Before Deferring Your Mortgage

“No part of the mortgage is forgiven, as many people assume.”

Given massive economic stress on millions of Canadians, Canadian banks are now offering the option to defer your mortgage for up to 6 months. If you’re considering deferring your mortgage payments, there are few key points you need to know.

Mortgage deferral is a fair option for those temporarily in a cash-squeeze as people remain locked-up in their homes. However, no part of the mortgage is forgiven, as many people assume.

The mortgage deferrals simply rearrange financing, potentially leaving you with more debt in the end.

According to the Canadian Mortgage and Housing Corporation (CMHC), which oversees insured mortgages in Canada:

The mortgage deferral agreement does not cancel, erase or eliminate the amount owed on your mortgage. At the end of the agreement, you will have to resume payment according to your regular payment schedule.

NOTE: The interest that hasn’t been paid during the deferral period continues to be added to the outstanding principal of your mortgage. This can affect the total amount you owe in accordance with the original payment schedule.

In other words, you will need to repay the deferred principal amount plus interest on that amount plus interest accrued on the interest.

After the mortgage deferral, you will likely be presented a variety of options by your mortgage lender. The two main options will probably be as follows:

  1. Repay the deferred principal and interest as a lump sum and continue with your regular mortgage payments. This will help you avoid paying interest on the interest, but obviously means you need a big chunk of money.
  2. Add the deferred principal and interest to your mortgage principal, and either increase your monthly payments (to accommodate the higher principal amount) or extend the length of your mortgage amortization. With this option, you will be paying interest on the interest deferred during the deferral period.

For many people there is no other choice but to defer mortgage payments.

If you defer your payments your cash-flow will improve. I suggest putting aside as much money as possible while you have the opportunity. Use this chance so you have more flexibility at the end of the deferral period.

If you must defer, you will need to seriously consider whether your situation will change after the deferral period. Will you be able to pay your mortgage after the deferral period? Consider your options and stay in contact with your mortgage provider if you don’t think the 6 month deferral will be enough.

Deferrals won’t last forever. Use this deferral period wisely.