How Inflation Affects Loan Instalments

“5 Ringgit for a bowl of curry noodles? In my day, it was 50 cents!” Sounds familiar? No doubt you hear your parents and grandparents griping about today’s prices more often than not.

The reason for these price differences is simple and straightforward – inflation. We will not delve into the mechanics of inflation and its causes here; all we need to know in this context is that it devalues a currency over time by increasing the prices of goods and services.

Let’s start from the beginning to find out how you can utilise this knowledge.

A Misled Mind-Set?

There’s a piece of conventional wisdom when it comes to housing loans – pay them off whenever you have spare cash, and the more you pay, the better it is as you will be done with them earlier.

However, the opposite could ring true if you take into account the inflation factor. Simply put, one Ringgit 30 years ago has a much higher value than its current counterpart due to inflation. Going by the same logic train, RM1 now would obviously be of higher value as compared to RM1 30 years down the line. A simple roadside meal which costs you RM3 today will probably cost RM15 in 30 years time.

Looking at things contextually, if you were to pay ahead on your housing loan instalments, you will be using Ringgit that is worth more as compared to years down the line.

Thus, would you not be losing out by paying more than you have to, despite shortening your loan tenure?

Inflation versus interest

Of course, the one major argument against this logic is that while you might save some money by outsmarting inflation, you would end up paying more anyway due to the huge amounts of interest over the years.

To gain a clearer understanding of the impact of inflation here, we have to get a little technical.

Let’s consider a home loan of RM450,000 paid over 30 years at a steady Base Lending Rate (BLR) of 4.2%. Your monthly repayment would work out to RM2,201.

For argument sake, let’s compare two hypothetical scenarios.

Scenario 1 – Standard repayments made to bank throughout tenure length.
Scenario 2 – An overpayment of RM100 is added on each month throughout the tenure length.

From the table above, it is noted that overpaying your monthly instalments consistently throughout tenure will save you RM30,729 in total.

But does that value reflect the actual value saved when taking inflation into account?

Let’s now look at the two different inflationary scenarios to get a picture of how much value you actually stand to save from repaying earlier. All calculations are based on the discounted cash flow of the mortgage amortisation.

* Discounted cash flow payment = Payment/ (1+ (inflation rate)) ^{no of months}

If average inflation rate in Malaysia is at 4% throughout the tenure:

The amount saved after taking inflation into account =  RM157 in today’s Ringgit

This is the value of the amount saved based on present day value.

If average inflation rate in Malaysia is at 5% throughout the tenure:

You actually don’t save any money but end up ‘losing’ money instead, in a sense. The total amount LOST after taking inflation into account = RM 2,786 in today’s Ringgit.

From here, it becomes clear that by overpaying and saving that additional RM30,729 in the future; when translated into today’s equivalent – the amount might be much less than you think simply because of the effect of inflation!

Summary

The above-mentioned scenarios were based on certain assumptions. What is more likely to happen is a random fluctuation in the BLR and inflation rates over time. Still, the principles shown hold true.

Here is how you can extract the maximum value from your Ringgit by following these 3 simple rules:

3 Rules To Get The Most Out Of Your RM

1. If Interest Rates > Inflation Rates, CLEAR OFF DEBTS.

2. If Interest Rates < Inflation Rates, SPEND YOUR MONEY.

*Use your money for either (a) Investments (b) Consumption Items

3. SAVE only as much as you need.

* In most situations, keep only a minimum amount of cash – in savings / FD etc, as your money generally devalues over time (though there are certain exceptions).

On a final note, please remember not to discount the importance of saving – it is necessary to have a rainy day fund and there might be times where that extra cash will come in handy. Do, however, practice wisdom and save just enough for practical purposes.

*This article was done in collaboration with Loanstreet.