What is Inflation and How Does it Affect Loans?

As of March 2022, the US inflation rate was 8.5%. The highest rate since December of 1981.

But what does that really mean?

Inflation has come to be viewed as a scary word. A recent survey found that 88% of American adults were concerned about inflation. Understandably so, as this concept has serious implications for our personal finances. It can impact many of your monthly expenses, and it can limit the growth of your savings.

It can even affect your loans.

To help you understand the relationship between inflation and debt, we’ve outlined everything you need to know about this financial buzzword.

 

What is Inflation?

Inflation is a sustained increase in the prices of goods and services over time. Conversely, when general price levels fall, it’s known as deflation.

High inflation causes things like food, utilities and gas to cost more. As a result, consumers experience a decrease in purchasing power — since prices of general expenditures go up, your dollars don’t go as far.

With that in mind, let’s walk through a few examples.

 

Examples of inflation

Let’s say a loaf of bread costs $1.00 today. If the annual inflation rate is 2%, the same bread will cost you $1.02 next year. A dollar this year won’t cover the full cost of the bread next year. In this sense, next year’s dollar has less value — because it has less purchasing power.

That may not seem like a huge deal but think about all the things you spend money on. Food, gas, clothing, utilities, medical care, loans, auto repairs — and those are just essentials. Prices for “entertainment” can rise too, such as streaming subscriptions or concert tickets. These things add up.

Inflation is most noticeable when it impacts larger expenses like the cost of housing. If you rent your home, chances are your landlord increased your rent in 2021. It’s normal for rental rates to increase 3-4% each year. But during times of high inflation, these rate bumps can be quite drastic.

According to Dwellsy, median rent prices went up 11% last year. And that’s just the median. Some cities experienced eye-popping increases. Miami, for example, saw rental rates climb by more than 23%. In context, a $1,000 rent check would’ve expanded to $1,230.  That’s another $230 going out the door each month.

Inflation also impacts savers. Let’s say you have an emergency fund set aside to cover unexpected expenses. You keep a few months of expenses in the account, which we’ll assume equates to $5,000 today. If the annual inflation rate is 5%, you’d need to deposit another $250 into your account to cover the same level of monthly expenses (5% x $5,000 = $250).

Even though savings accounts pay interest, the return is rarely enough to counteract the inflation rate.

 

How is inflation measured?

To monitor inflation, economists and policymakers typically look at specific baskets of goods and services. These “baskets” are also referred to as indexes. For instance, the most commonly used metric for tracking inflation in the US is the Consumer Price Index (CPI).

Each month, the CPI measures the prices of common consumer purchases, such as food, clothing, transportation and shelter. In other words, goods and services that generally classify as necessities. So, it’s a useful benchmark for changes related to the cost of living in urban or metropolitan areas (it doesn’t account for rural locales).

 

What Causes Inflation?

At any given moment, there are a wide variety of macroeconomic forces at play. Consumer demand, labor capacity, availability of materials, fiscal policy — not to mention extraordinary events like the COVID-19 pandemic. As a result, several factors can contribute to inflation. Let’s walk through a few of them.

Demand-pull inflation happens when aggregate demand for goods and services outpaces production. There isn’t enough supply, so prices rise in response. Super Bowl tickets are a prime example. The number of people who want to attend the Super Bowl is typically much greater than the number of tickets available for purchase (i.e., demand is greater than supply). As a result, people often wind up paying much more than the face value for a ticket on secondary exchanges.

Cost-push inflation happens when it becomes more costly to produce goods and services. For example, if the cost of oil rises, it becomes more expensive to produce and transport goods. These higher production costs lead to a decrease in supply and an increase in prices.

However, it’s important to keep in mind that these aren’t the only catalysts of inflation. Public policy can be another factor. In response to the pandemic’s economic fallout, the government distributed several stimulus checks to US citizens, which effectively flooded the country with more cash. When the money supply increases, the value of an individual dollar can fall (i.e., inflation rises).

 

Inflation and Debt: The Impact on Loans and Interest Rates

Yes, inflation can affect your loans and their respective interest rates. But the important word is “can.” Let’s go through how higher inflation rates can influence interest rates and even your existing loans — starting with the governing body responsible for setting inflation expectations: the Fed.

The Federal Reserve is the central bank of the US. It’s responsible for regulating financial markets, controlling the money supply and setting interest rates. To do so, the Fed dictates the country’s monetary policy. For instance, it may lower short-term interest rates in hopes of fueling economic growth, which is often measured by gross domestic product (GDP). Or the Fed might buy government bonds from the US Treasury to stimulate economic activity too.

Conversely, in the event of rising prices and an “overheated” economy, the Federal Reserve may raise interest rates to keep economic growth (and inflation) in check.

Why do higher interest rates tend to slow inflation down? As interest rates increase, borrowing money becomes more expensive. With more money going out of bank accounts to make interest payments, people and businesses spend less money elsewhere. Demand decreases — which can help supply return to normalized levels.

But what impact does increasing interest rates have on you as a borrower?

 

How does inflation affect loans with variable rates?

When the Fed raises short-term rates, it typically trickles down to Wall Street and lending institutions — meaning banks raise their interest rates too. So, if you have a variable rate loan and rates go up, your interest payment will experience a proportional increase.

For example, let’s assume you have a 30-year, $250,000 adjustable-rate mortgage (ARM) that charged a fixed rate for 2 years followed by a variable interest rate for the remaining 28. Your opening rate was 4%, so your monthly loan payment was $1,194 for years one and two. However, starting in year three, your rate adjusts to the market. For the purposes of our example, we’ll assume inflation rates rise unexpectedly. This prompts regulators and, in turn, banks to raise interest rates. Now, your variable rate is 5% and your monthly payment jumps to $1,334.

 

How does inflation affect loans with fixed rates?

Unlike variable-rate loans, fixed-rate loans do exactly what their name implies — remain the same. Using the above example, let’s replace your ARM with a 30-year, $250,000 fixed-rate mortgage. This time, when inflation rises and interest rates increase, your loan is unaffected. You’re protected by the terms of your loan agreement.

 

Does Inflation Favor Lenders or Borrowers?

Naturally, when the economic forces shift, some people and businesses benefit while others experience drawbacks. When it comes to lenders and borrowers, inflation can favor both — or neither. It depends on other factors, let’s break a few down.

 

How inflation can benefit borrowers

Inflation can benefit borrowers if they have fixed-rate loans. As we outlined above, if interest rates rise, existing loans won’t be affected.

On top of that, your loan payments might become less of a burden if your take-home pay increases, which can happen as a result of inflation. For example, during labor shortages, lawmakers may raise minimum wage requirements and companies may boost salaries to attract and retain talent. Although this can lead to even higher inflation, it indirectly makes existing loans more affordable.

However, inflation can also make living more costly, which may offset this benefit.

 

How inflation can benefit lenders

Rising levels of inflation typically prompt the Federal Reserve to raise interest rates. This has a domino effect on lending rates, which often move in tandem with the fed’s rate hikes or drops. If lenders have a lot of variable rate loans, such as adjustable-rate mortgages or credit cards, they could benefit from rising rates.

Additionally, higher prices can make it more difficult for people to afford their usual lifestyle. Paychecks may not go as far as they used to, spurring people to take out loans or use credit cards to pay for wants and needs. In that case, lenders benefit from new customers.

However, they only benefit so long as borrowers make payments. From a lender’s perspective, loans are considered assets as well as liabilities. If people borrow more money but fail to repay their debt (i.e., default on their loans), lenders lose too because they don’t get their money back.

 

Bottom Line

Inflation can be a sign of a growing economy, so it isn’t inherently bad. That said, when inflation spikes and price volatility occurs, many tend to fear the worst.

If you’re striving to safeguard your finances from inflation, RISE is here to help. Check out our free, interactive tools for setting savings goals and managing debt, and stay tuned to our blog for more tips on improving your financial knowledge. And if you do find yourself in need of financial help, a fixed-rate loan from RISE lets you borrow what you need, when you need it. You can even pay off early with no extra fees.  That’s one of the reasons why for millions of Americans RISE is a better way to borrow.