The Impact of Inflation on Lending

The Impact of Inflation on Lending

Inflation has become a major concern for many parts of the economy in 2023, and the lending industry is no exception. Rising prices affect both lenders and borrowers in significant ways. In this blog post, we'll examine how high inflation impacts various areas of lending.

Interest Rates

One of the most direct effects of inflation is that it typically causes interest rates to rise. As the Federal Reserve raises rates to try to slow economic growth and control prices, the prime rate that banks use as a baseline for loans also increases.

Higher interest rates make borrowing more expensive. For example, say you take out a $300,000 mortgage. With an interest rate of 3%, your monthly principal and interest payment would be around $1,265. At an interest rate of 6%, your payment would jump to $1,799 per month. That's an extra $534 per month or $6,408 per year that you'd pay in interest costs.

On adjustable-rate loans and credit cards, payments can rise even faster when rates increase. This reduces consumers' purchasing power and makes loans less affordable.

For lenders, higher interest rates are a double-edged sword. On one hand, they can charge more interest on new loans. This boosts their profit margins. However, if rates rise too fast, it can reduce demand for mortgages and other loans. Borrowers get priced out of the market.

Loan Performance

Another impact of high inflation is that it can weaken loan performance. As consumers' costs go up faster than their wages, they have less disposable income to make loan payments.

This is especially true for borrowers who are living paycheck to paycheck with little savings. For example, if grocery bills rise 15% but your pay only goes up 3%, you'll have less money by the end of the month for other expenses.

Credit card delinquencies are one area where this can show up. When cardholders struggle to pay the minimum due, banks write off more bad debt.

With mortgages and auto loans, borrowers may try to keep making payments by cutting expenses elsewhere. But some will inevitably fall behind. Higher defaults and lower recoveries on foreclosed properties also hurt lenders' profits.

Adjustable-Rate Mortgages

Inflation impacts fixed-rate and adjustable-rate mortgages differently. Many ARMs have caps that limit rate hikes. However, payments on ARMs can still rise significantly when the underlying index shoots up.

This happened in the late 1970s and early 1980s when some ARM rates spiked over 10% or even 15%. Sudden payment shocks resulted in higher delinquencies for lenders.

Fixed-rate mortgages held up better as they kept payments steady. But high inflation at that time meant interest rates for new fixed-rate loans were above 10% or even up to 18% briefly. This reduced affordability and new mortgage demand.

Today's ARMs often have tighter caps on increases. But the Federal Reserve has had to raise rates so rapidly that even capped ARMs can see sharp payment increases. This will present challenges both for ARM borrowers and lenders over the next few years.

Home Values

Rising home prices can benefit lenders when home values increase faster than mortgage loan balances. This provides lenders more security if borrowers default. The lenders can foreclose and recover a higher property value.

However, rapid home price growth can also encourage looser lending standards and higher mortgage defaults during economic downturns. This occurred during the mid-2000s housing bubble.

Eventually, extremely high home prices must come back down to affordable levels. When prices correct lower, as they did after the housing bubble burst, homes may end up "underwater" with loan balances higher than deflated values. This provides little foreclosure recovery for lenders and increases losses.

Therefore, stable moderate home appreciation, rather than big price swings, provides the best scenario for lenders. High inflation often comes with rapidly rising and falling home values, which lenders need to manage carefully.

Operational Costs

Inflation doesn't only affect interest rates and borrowers. Lenders themselves face higher operating expenses too. As wages, property prices, technology tools, and other business costs rise, this squeezes profit margins.

Lenders must find ways to become more efficient and raise fees to maintain profitability. Otherwise, high inflation can transform what had been a healthy interest rate spread into an unprofitable lending environment.

The Last Major Inflation Period

The late 1970s/early 1980s provides a good case study for how high inflation can wreak havoc on lending. Double-digit inflation led to mortgage rates spiking over 18%. Defaults skyrocketed, especially for people who had taken out ARMs.

Lenders faced massive losses, and many savings and loan institutions failed. Accounting rules at the time exacerbated the crisis, as they allowed banks to count unrealized gains on long-term bonds as current income. When interest rates later fell, those paper profits turned to large losses.

The entire savings and loan industry struggled. Of around 4,000 S&Ls in the early 1980s, over 1,300 failed by the end of the decade. The government had to take over and close hundreds of insolvent thrifts.

Could That Happen Again?

Critics raise concerns that lenders today are ignoring the potential impacts of inflation based on false confidence that "this time is different." However, there are some important differences between the high inflationary period of the 1970s/1980s and today:

  • More prudent capital requirements help ensure lenders have enough reserves to weather downturns.
  • Adjustable-rate mortgagecaps prevent rates from spiking as high.
  • Lending standards have been tighter in recent decades, especially for mortgages.
  • The Federal Reserve has more tools, like its bond buying programs, to intervene if needed.
  • The economy is less dependent on volatile manufacturing and commodities today.

While these factors should help, if inflation remains stubbornly high, it will strain both lenders and borrowers. The Fed would likely need to keep interest rates elevated for years, putting downward pressure on lending and growth.

Key strategies lenders should consider to navigate inflation risks include:

  • Maintaining conservative underwriting standards, even if competitive pressures build to lower them.
  • Keeping a healthy level of loan loss reserves.
  • Using interest rate hedges and other tactics to manage unpredictable rate swings.
  • Diversifying lending products to reduce reliance on areas like ARMs and jumbos.
  • Focusing on fee income opportunities so rising rates also improve net interest margins.
  • Controlling operating costs wherever possible.
  • Keeping a close watch on portfolio performance trends to catch any deterioration early.

With prudent preparation and adaptable strategies as conditions change, lenders can manage through inflationary periods. While the current environment presents challenges, the lending industry today is in a stronger position compared to previous decades.