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Debts, Interest and Inflation

THE INTEREST RATE YOU’RE CHARGED on a loan will likely bear some relationship to the current inflation rate. Prevailing interest rates are typically above inflation, so that lenders make money, even after the corrosive impact of inflation is factored in. In the case of mortgages and car loans, the premium over inflation may be relatively modest. In the case of credit cards, it can be huge.

That might make high inflation seem like a major enemy, just as it is for investors. But it depends on the type of loan. Rising inflation and rising interest rates can be bad news for borrowers if they have loans with floating interest rates, such as credit card debt and adjustable-rate mortgages. It’s a different story, however, with fixed-rate loans.

Imagine that you took out a 30-year fixed-rate mortgage at 4%, at a time when inflation was 2%. If inflation then accelerated to 5%, your mortgage payments would stay the same, but your salary would likely increase with the inflation rate. Even though your income is worth no more in inflation-adjusted terms, you would be better off because a major expense—your mortgage—hasn’t increased along with consumer prices.

We saw this scenario in the high inflation 1970s.  Homeowners with mortgages were major beneficiaries, while those who lent to them suffered, because the loans were repaid with depreciated dollars. If inflation picks up from today’s modest level, we could see the same phenomenon again. What if, instead, inflation and interest rates fall from today’s already low levels? As we discuss later, this might be a reason to refinance fixed-rate loans or pay down debts faster than scheduled.

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Previous: Where We Stand: Debt

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