An alternative type of mortgage loan is called a price-level adjusted mortgage (

Question

An alternative type of mortgage loan is called a price-level adjusted mortgage (PLAM), which sets all mortgage payments and the principal amount of the mortgage in real rather than nominal terms. Thus, if the inflation rate was 10 percent in a certain year, the monthly payment would be increased by 10 percent in dollar terms, and the principal value of the mortgage loan also would be increased by 10 percent in dollar terms. Who gains from this type of mortgage-the homeowner or the bank of both? Explain. Who bears the inflation risk?

Explanation / Answer

The principal amount and the interest payments are continually increased by the rate of inflation. Here, both the parties (Bank and home owner) exposed to the risk of 'unexpected' inflation. So, both the parties the banker and homeowner would bear the inflation risk. If the rate of inflation is high, then mortgage interest rates need to be higher, or the lender will actually be losing buying power. When inflation is low, then mortgage interest rates are low (though still higher than the rate of inflation) because the demand for loans is usually low

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