Thursday, 20 January 2011

Borrow to pay interest: it can make sense given significant inflation.

With inflation and interest rates probably on the rise in the UK over the next year, we can expect the usual long queue of yawn provoking commentators telling us that this makes life more difficult for borrowers. The reality is that when interest rates and inflation rise by the same amount, the cash flow position for borrowers would not be affected one iota if they got to grips with inflation accounting. I’ll explain.

A loan involves two elements: first paying interest, and second, gradually repaying the capital sum. Let’s assume, 1, a £100k loan, 2, that interest is 5%, 3, repayment of capital is 5% a year, and, 4, that inflation is zero.

Total payments in the first year will be 10% of the sum borrowed.

Now let’s assume inflation of 15% with the REAL rate of interest the same, i.e. 5%, which makes the APPARENT rate of interest 20%. In this scenario, how would a borrower and lender with their heads screwed on (i.e. acquainted with inflation accounting) go about arranging matters so that the outcome IN REAL TERMS was the same as in the zero inflation scenario?

At the end of the first year, the outstanding loan needs to be £95k in real terms (i.e. in terms of prices as they were 12 months earlier). But wait a moment: £95k adjusted for 12 month’s worth of inflation is £95k x 120% = £114k. In other words the borrower needs to borrow an extra £19k just to make sure the value of the capital sum borrowed declines at a nice steady rate IN REAL TERMS.

To summarise, given a significant rate of inflation, if borrower and lender do their inflation accounting properly, the amount borrowed in nominal terms will initially RISE: counter intuitive.

Alternatively the borrower can make their own arrangements and get a second mortgage or loan with a view to borrowing the above extra £19k.

During the high inflation episode around 1970, lenders and yawn provoking commentators in the UK totally failed to get to grips with this point. If inflation becomes serious again, they will probably fail again. The above point is a mile above their pretty little heads.

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