Inflation! – Step one, understanding the problem.

Inflation and Indexation

Inflation in Iceland has been a big problem in the past. 30-50% inflation rate have been a reality in past. But in the last two decades, the inflation has been pretty even, for example between 2000-2012 the inflation rate was 5.9 % at average. In the years between 1970-1980 the inflation rate was so high that the purchasing power of the average home increased so fast that the banks in Iceland were actually losing money by lending it. So the government and the banks decided that the best way to protect the banks is to lend with an inflation indexation, in other words now the banks can’t lose money, regardless of the inflation.

The inflation indexation is calculated monthly on top of the capital of the current loan amount.

Example:

You borrow 100.000 dollars (Iceland equivalent about 12.8 million kronur) for 25 years and your first payment is scheduled to be $335 of the capital plus $335 for interest, the first month based on 4% yearly interest rate, leaving the balance of $99.665. In this example we will use the average inflation rate between 2000-2012, which was 5.9%. That means that the correction (indexation) added to your loan will be $479 leaving you with a total balance of $100.144 after the first month’s payment.

Of course you see that the loan has to be recalculated each month based on the accurate inflation rate and those months that have more inflation your loan amount will actually increase more. Here is a typical illustration of the lifetime of an inflation indexed loan. 

source: https://www.landsbankinn.is/einstaklingar/lan-og-fjarmognun/ibudalan/reiknivel/ – loan calculator.

Your capital will not go under $100.000 until after about 15 years, based on the inflation rate and interest used in this example (very realistic numbers used based on the past). Your payments go up each month during the lifespan of the loan. First payment $670 and your last payment in 25 years from now would be $1.402 (if we can assume that the average inflation rate will stay steady throughout the time period). You’re total re-payments are around $309.500 for the 25 year loan.

The indexation is helping the banks but not the people, it is happening all the time that people can’t pay their mortgage any more and therefore lose their house. Those people have to find a place to rent and the owners of those houses are struggling with the indexed loans themselves so they have the renters pay indexed rent (adjusted to inflation). Now you (the reader) can see how this has a snowball effect on the economy.

Currently there are very few homes that are good investments in Iceland, but somehow the industrial market has not been affected as much as private properties, I assume it’s because professional investors are buying those properties, but I could be wrong.

Example:

Good investment should be a $100.000 property, that you can rent for about $1.000 per month.

$100.000 apartment in Iceland can return about $600-800 rent per month depending on location.

$100.000 industrial property can return about $900-1.100 rent per month, depending on location.