Budgeting Interest Rates Loans

How Does Inflation Affect Borrowers?

We’ve all heard the term inflation when discussing economics, especially in 2022, but how does inflation affect borrowers?

You may have recently heard or read about predictions of inflation rates after the pandemic. We all know that inflation is generally a red flag for consumers. But what does inflation mean for borrowers? The good news is that inflation can be positive in some ways if you are a borrower, but there are some caveats to this. Keep reading for some of the basics about inflation and its impact on borrowers. 

What Exactly Is Inflation?

According to the Federal Reserve, inflation is the general increase in prices and goods over time. Economists use seven tools to measure inflation rates and predict future trends. Most of these tools measure price changes in goods and services across various industries—for example, food, energy, cost of living in different locations, and healthcare. 

With inflation, there is also a fall in purchasing power. Purchasing power is the number of goods and services you can get for a single dollar. And so, the lower the rate of inflation, the farther your money goes and vice versa.

The Impact of Inflation on Loans and Interest Rates

When inflation occurs, the demand for credit and loans increases. And for new borrowers, interest rates will reflect market trends and the economy, which will mean higher rates than in pre-inflation days—both of these factors benefit lenders.

If you are a borrower who took out a loan before inflation and your loan had a fixed interest rate, your repayment amount will stay the same as the economy changes. While variable interest rates will likely rise, as lenders will want to make up for the loss in value. 

And so, when you have fixed interest rates on a loan that you took out before inflation, it will likely be a better deal to stick with the older loan instead of refinancing, as interest rates will be higher to reflect trends of the economy. If you are a new borrower during high inflation, shop around and put your best financial foot forward to get competitive interest rates. 

Do Borrowers Benefit From Inflation? 

Inflation actually can benefit borrowers. The way that this works is pretty simple, if you are a borrower and inflation occurs while repaying, the money you had borrowed will have more purchasing power and thus more value than the money you owe. In other words, the money you borrowed and used was worth more than what your lender is getting back, even if, on paper, it is the same principal and interest amount. 

You will likely see this benefit with longer loans, for example, student loans, mortgages, and car loans. Smaller loans like poor credit monthly installment loans and credit cards will likely not be primarily impacted by inflation as a borrower repays them—as inflation can take several years to build up.

If you are a borrower whose loan has an asset, there can be even more benefits. In addition to the lower value you owe due to inflation, if you decide to sell your asset after paying off the loan (in some cases before), you could potentially get more value from that asset than before inflation. For example, a home may sell for much more during inflation vs. deflation. 

An Example of a Positive Impact for Borrowers

Here is a quick example that can help you better understand how this works: 

Let’s say you borrowed $50,000 of student loans in 2010 and are still repaying it in 2022; with the current inflation rate, that $50k that you borrowed will actually be worth $65,924.35. But you don’t have to worry about paying back that $15,924.35 value increase. 

Negative Impacts of Inflation for Borrowers

When it comes to the negative impact on borrowers, you will pay higher interest rates if you take out a loan during inflation. For a loan like a car loan or mortgage, you will likely need to qualify for a higher loan amount, as the prices of goods will be higher.

If inflation is followed by wage increases and money circulation, people’s quality of life levels out. However, when inflation happens without these balancing factors, it can be more challenging for Americans to afford the same standard of living before price increases. 

With inflation, you will be paying more for everything. And if your wages don’t increase by much, and history shows that this is pretty common, then affordability will go down even further. With these changes, repaying your debts as a borrower may become a little more complicated. And if you’re already budgeting with irregular income, this may make it even more difficult. These challenges may be tackled by:

  • Budgeting differently to make debt repayment a priority.
  • Looking at higher-paying jobs/negotiating your salary.
  • Simply refinancing even for higher interest rates if that means a more manageable monthly payment on your debts. 

An Example of a Negative Impact of Inflation When Borrowing Money

Here is an example using a mortgage to show how inflation can negatively impact a borrower: 

Let’s say the year is 2010, and you are trying to buy a home in Chicago. Home prices average at $145,500, and the average down payment is 4.3%. If you were looking for a home in the same area in 2022, the median home cost is $339,000 (close to a 50% raise!) with an average down payment of 20%. Not only will home costs be higher, but it will also be more expensive to close and pay everyone involved with the homebuying process. On top of that, wages only increased by approximately 2% each year in the last decade. 

And so, as you can see, there are definitely negative impacts that borrowers should consider when taking out a loan when inflation rates are high. 

The Bottom Line for Borrowers

Inflation will have both negative and positive impacts on borrowers. And although you can’t do much about where the economy is at, there are things as a borrower you can do to get the best loan option. Improving your credit score, looking at several lenders to find the best option, and showing all of your income sources can help increase the quality of your loan and the loan amount, regardless of what inflation rates are. 

References:

Inflation Calculator
Chicago-area home sales in 2010 dipped to lowest level in a decade
Chicago, IL Real Estate Market | realtor.com®
Nominal Wage Tracker | Economic Policy Institute
The Fed – What is inflation and how does the Federal Reserve evaluate changes in the rate of inflation?
Prices & Inflation | US Bureau of Economic Analysis (BEA)
Lesson summary: The costs of inflation (article) | Khan Academy