Question

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

Short answer

An increase in inflation generally leads to central banks raising their benchmark interest rates, which in turn affects the index rate tied to adjustable-rate mortgages (ARMs). Consequently, the interest rate on an ARM will increase during its periodic reset, resulting in higher borrowing costs for homeowners with such loans.

Step-by-step solution

Understand Inflation

Inflation is the rate at which the general level of prices for goods and services is rising over time. This causes the purchasing power of money to decrease. Inflation is measured as an annual percentage increase using the Consumer Price Index (CPI) or the Wholesale Price Index (WPI).

Understand Adjustable-Rate Mortgages (ARM)

An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate applied to the outstanding balance varies throughout the life of the loan. The initial interest rate is usually fixed for a period, after which it resets periodically (such as annually or monthly) based on an index (such as the London Interbank Offered Rate or the U.S. Prime Rate) plus a margin (additional percentage points added by the lender).

Relationship Between Inflation and Interest Rates

In general, there is a positive relationship between inflation and interest rates. As inflation increases, central banks often try to control it by increasing their benchmark interest rates. This move affects other interest rates in the economy, such as those for loans and mortgages, including adjustable-rate mortgages.

Effect of Increased Inflation on ARMs

Now that we understand the relationship between inflation and interest rates, we can answer the original question: How should an increase in inflation affect the interest rate on an adjustable-rate mortgage? When inflation increases, central banks tend to raise their benchmark interest rates. As a result, the index rate to which the ARM is tied will also likely increase. In turn, the interest rate on the adjustable-rate mortgage will increase as well when it goes through its periodic reset. This means that the cost of borrowing for homeowners with adjustable-rate mortgages will increase, as they will need to pay higher interest rates on their outstanding mortgage balance. In summary, an increase in inflation can lead to higher interest rates on adjustable-rate mortgages, causing homeowners with such loans to face higher borrowing costs.