Question

How should an increase in inflation affect the interest rate on an adjustable- rate mortgage?

Short answer

An increase in inflation typically leads to higher reference interest rates set by central banks. As the interest rate on adjustable-rate mortgages (ARM) is directly linked to reference interest rates, a rise in inflation will generally lead to an increase in the interest rate on ARMs, resulting in higher monthly mortgage payments for borrowers.

Step-by-step solution

Understanding Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and consequently, the purchasing power of currency is falling. In simple terms, when inflation is high, the value of money decreases, and as a result, the price of goods and services increases.

Relationship between Inflation and Interest Rates

Central banks attempt to limit inflation and prevent deflation by adjusting the interest rates. When inflation is high, central banks usually increase interest rates to reduce the amount of money in circulation, ultimately decreasing the inflation rate. Conversely, when inflation is low or there is deflation, central banks might decrease interest rates to stimulate economic growth and increase the inflation rate. Therefore, there is a direct relationship between inflation and interest rates.

Understanding Adjustable-Rate Mortgages

An adjustable-rate mortgage (ARM) is a type of mortgage where the interest rate can change periodically, depending on a reference interest rate and a margin set by the lender. The initial rate on an ARM is typically lower than a fixed-rate mortgage, and it will remain constant for a specific period (usually 3, 5, 7, or 10 years). After that period, the interest rate on the ARM adjusts periodically (usually annually) based on fluctuations in the reference interest rate, such as the U.S. Prime Rate or London Interbank Offered Rate (LIBOR).

Effect of Increase in Inflation on Adjustable-Rate Mortgages

Given the direct relationship between inflation and interest rates, when inflation rises, the reference interest rates usually increase as well. As a result, the interest rate on an adjustable-rate mortgage will also increase as it is directly linked to the reference interest rate. This means that the monthly mortgage payments for borrowers with ARMs will rise in response to higher inflation. Therefore, an increase in inflation will generally lead to an increase in the interest rate on adjustable-rate mortgages.