With current mortgage rates relatively high, everyone is looking to find mortgage products that might ease the pain of high monthly payments. Inflation Linked Mortgage (ILM) products are often thought of as a good alternative with low rates and low monthly payments. But there is more to it than that. Much more. Let’s take a look at what is really involved with inflation linked mortgages.
How Do Inflation Linked Mortgages Work?
At the end of each month, the bank takes the principal balance, multiplies that figure by the inflation rate for the month and adds that amount to the principal. It then recalculates the monthly payment based on the new, usually higher, principal balance (note: when there is negative inflation, the principal does not decrease, but remains unchanged). So, on a NIS 2 million shekel mortgage, when inflation is running at 4% (or 0.333% per month) at the end of the very first month, the bank will add NIS 6,667 to the principal balance. The mortgage payments are then continuously recalculated throughout the life of the mortgage in order to account for the impact of inflation.
When comparing ILM rates to unlinked products, this is what you may find;
– Rates on ILM’s are significantly lower than similar products that are not linked to inflation – sometimes as much as 1.5% lower. So, while a fully fixed rate mortgage might be 5%, a fixed rate ILM could be as low as 3.5%.
– On a 2 million shekel, 20 year, 3.5%mortgage the ILM would result in initial monthly payments of only NIS 11,599 compared to payments of NIS 13,199 for the unlinked 5% mortgage – a significant saving.
– Before taking inflation into account, payments on the ILM would total NIS 2.78 million, compared to NIS 3.16 million for the unlinked mortgage, a savings of almost NIS 400,000 over the life of the mortgage.
But let’s see what happens when the linkage starts to kick in.
The average inflation rate over the last 20 years has been approximately 1.8% and is probably a good number to work with.
The monthly payments would rise to NIS 13,199 (the same as the payments on the 5% mortgage) after about 7 years and at its peak would reach over NIS 16,000.
The impact of only 1.8% average inflation would add almost NIS 570,000 to the total payments, more than wiping out the hoped for savings. The effective interest rate on that original 3.5% mortgage now turns out to be almost 5.7%.
Now let’s take a look at what would be the case if inflation continued at it’s current 4% level.
Monthly payments would reach NIS 13,199 after only 3 years and peak at over NIS 25,000.
Total payments over the life of the mortgage would increase by almost NIS 1.5 million.
The resulting effective interest rate would be a whopping 8.84%.
Here is a chart that will give you a frame of reference, including the unlikely event of inflation averaging 6% over the life of the same 20 year mortgage.
Another unintended consequence of the ILM is the possibility of Negative Amortization – when the principal balance on a loan increases instead of decreasing. It means that the portion of the monthly payment that is allocated to paying off principal is insufficient to offset the impact of the increase in principal caused by the linkage to inflation.
Using the above example with 4% inflation, the impact of linkage at the end of the first month is an increase of NIS 6,667. However, the first payment of NIS 11,599 only includes NIS 5,747 to pay off principal. Hence, the principal at the end of the first month increases by NIS 920. In this same scenario, the linkage increase continues to outpace principal payments for almost 5 years.
While Inflation Linked Mortgages may look inviting, there is much more to them than meets the eye. The intricate mechanics of these mortgages can lead to unexpected financial burdens. When considering mortgage options, it’s crucial to account for potential inflation effects and consult with financial advisors to make an informed decision that aligns with your long-term financial goals. Remember, a mortgage is a significant commitment, and understanding the nuances can save you from unforeseen challenges down the road.