Question

Many home mortgages in recent years have been made with variable interest rates. Typically, the interest rate is adjusted once a year on the basis of current interest rates on government bonds. How do variable interest rate loans protect creditors from the effects of unexpected inflation?

Short answer

Short Answer: Variable interest rate loans protect creditors from the effects of unexpected inflation by adjusting the interest rates based on the rates of government bonds, which are influenced by inflation. When there is unexpected inflation, government bond rates generally increase, which in turn pushes up the variable interest rate on the loan. This compensates the creditor for the loss in the real value of money caused by inflation, ensuring that they receive adequate returns on their lent funds.

Step-by-step solution

Understanding Variable Interest Rates

Variable interest rates are interest rates that change over time based on the market or an external financial index. In the context of home mortgages, they are typically adjusted once a year on the basis of current interest rates on government bonds. This means that if the interest rates on these bonds increase or decrease, the interest rate on the loan will be adjusted accordingly.

Impact of Inflation

Inflation is the rate at which the general level of prices for goods and services is rising and, subsequently, purchasing power is falling. If there is unexpected inflation, the real value of money decreases, and creditors end up receiving less in terms of purchasing power when the debt is repaid than when they originally lent the money.

Government Bonds and Inflation

Government bonds are considered relatively safe investments, as they are backed by the government. They pay periodic interest payments, called coupon payments, based on a specified rate. Typically, government bond rates are influenced by the inflation rate – when inflation is high, interest rates on government bonds increase and vice versa.

Variable Interest Rates Protecting Creditors

Now, let's understand how variable interest rate loans protect creditors from the effects of unexpected inflation. Since variable interest rates are adjusted based on the interest rates on government bonds, they indirectly account for inflation. When there is unexpected inflation, the interest rates on government bonds usually increase as a response. As a result, the variable interest rate on the loan will also increase. This means that, even if the real value of money decreases due to inflation, the creditor is compensated for that loss through higher interest payments. Thus, the variable interest rate loans help protect creditors from the effects of unexpected inflation.

Key concepts

Understanding Inflation

Inflation is an economic phenomenon that represents the increase in prices for goods and services over time, which corresponds to a decrease in the purchasing power of currency. A simple way to think about inflation is to imagine how much a basket of groceries costs today compared to a year ago; if the price has increased, the value of the currency used to buy that basket has effectively decreased.

In terms of variable interest rate loans, inflation plays a significant role. Lenders set higher interest rates when they anticipate inflation, to ensure that the money they will be paid back in the future will have the same purchasing value as the money they lent out. If the lenders did not do this, the money repaid to them could potentially buy less than when they originally made the loan, due to the inflation-induced price increases.

The Role of Government Bonds

Government bonds are a type of debt security issued by a government to support government spending and obligations. Investors buy bonds as they provide regular income through interest payments, known as coupon payments. The relationship between government bonds and interest rates is inverted - when interest rates rise, bond prices usually fall, and vice versa.

When considering variable interest rate loans like home mortgages, government bonds can act as a reference for adjusting rates. If inflation expectations rise, the central bank may increase interest rates to cool down the economy, thus increasing the yield on newly issued government bonds. Consequently, holders of existing bonds with lower interest rates find their bonds less valuable compared to new ones with higher yields.

Purchasing Power and Inflation

Purchasing power refers to the number of goods or services that can be bought with a unit of currency. In times of inflation, purchasing power is eroded as prices increase. For example, if your monthly expenses were \(1,000 last year and inflation runs at 5% for the current year, you would need \)1,050 to cover the same expenses this year. To maintain your standard of living, your income must also increase by at least 5%.

For creditors, preserving the purchasing power of the money they lend is crucial. Variable interest rate loans, which adjust in response to fluctuations in interest rates influenced by inflation, are meant to protect creditors from losing out. When inflation causes prices to rise, the interest rate on these loans goes up, which can help maintain the linchpin balance between the value of money now and when the loan is repaid in the future.