How Does Inflation Affect a Loan?

With the rising costs of goods and services, many Americans are taking a step back and wondering just where this increase is coming from.

21:50 18 July 2024

Understanding Inflation and Its Effects

With the rising costs of goods and services, many Americans are taking a step back and wondering just where this increase is coming from. Inflation is a term you may have heard as a potentially linked culprit. Although its far reaching effects and causes are complex, the definition is quite simple. By definition, inflation is the overall increase in the prices of goods and services in an economy. Inflation is a constant, and it is natural that the cost of items increases overtime. However, the rate of inflation is important.

High inflation means that prices are increasing quickly. In general, high inflation usually hurts the economy. However, it is important to understand that extreme deflation, or when prices drop for consumers, is not desirable for the economy either. On the other hand, low inflation occurs when prices increase more slowly over time. In this type of economy, those who invest heavily in their savings can greatly benefit.

Causes of Inflation

There are many layered reasons as to why inflation occurs. The causes of inflation can be broken down and broadly categorized into the following 4 causes:

1. Demand-Pull Inflation
2. Cost-Push Inflation
3. Built-In Inflation
4. Monetary Inflation

First, demand-pull inflation occurs when there is a shortage of supply, but a high demand for product. This drives the cost of products up drastically. Cost-Push inflation is something that occurs when there is an increase in the cost of a vital or important good or service. Typically in this situation, there is no type of alternative available. Built-in inflation is unique in the sense that it is determined by events. For example, built-in inflation can occur when workers demand a higher wage to keep up with the cost of living. This can therefore drive up the cost of products to make up for the increased cost of wages. Finally, monetary inflation occurs when the money supply in an economy grows at a faster rate than that particular economy’s ability to produce goods and services.

The Effects of Inflation

While the causes of inflation are varied, so are the many effects that inflation can have on both consumers, the economy and businesses.

One major way in which consumers feel the effects of inflation is in their purchasing power. When prices rise, your money can buy less.

Additionally, while inflation can impact a variety of consumers, it has a disproportionate effect on lower income consumers. When the cost of necessary goods and services rise, those with a tighter budget have less “wiggle room” to accommodate these shifts. Lower income consumers typically have tighter budgets, and when the prices of mandatory goods rise, they have to pull from other areas of an already strict budget. Furthermore, only about 20% of low-income individuals make up the population of homeowners. Owning real estate is considered an inflation hedge, or, an investment that protects against the loss of purchasing power due to inflation.

The Impact of Inflation on Borrowers and Lenders

The two most important parties in any loan transaction are the borrower and the lender. Inflation affects borrowers and lenders in a variety of ways.

In examining the role of the borrower, it is important to understand that inflation can greatly impact a borrower in both positive and negative ways.

Inflation can be advantageous to a borrower in the sense that it reduces the real debt burden. Since inflation reduces the real value of money, and if a borrower has debt, the technical real value of their debt decreases. Although the monetary amount remains the same, in real terms this becomes “cheaper.”

However, on the other hand, inflation breeds uncertainty and unpredictability: two words you never want to hear associated with budgeting, lending or money. High inflation can generate uncertainty about future costs and make it extremely difficult for borrowers or future borrowers to plan for the future. This in turn can lead to more cautious borrowing, and even lenders being more cautious of the loans they approve.

The impact inflation has on lenders is also twofold. While an advantage for borrowers is that inflation makes their debt “cheaper” this has an opposite effect on lenders. When inflation decreases the real value of the return on their loans, lenders tend to suffer. In this instance, lenders may raise interest rates, which in turn allows them to get more of a return on their loans and to sometimes discourage borrowing.

The Link Between Inflation and Loans

While inflation greatly impacts borrowers and lenders in unique ways, inflation can also affect loans and the entire loan process. The following aspects of a loan are impacted by inflation:

• Interest Rates
• Loan Agreements
• Policy Responses

First, interest rates are impacted greatly by inflation. As previously discussed, as the real value of debt or a loan decreases, lenders may adjust their interest rates accordingly in order to get the same real value return on a loan. Furthermore, lenders may adjust the nominal interest rates, or the rate of a loan before any inflation. Typically the higher the inflation, the higher the nominal interest rate adjustment.

Secondly, loan agreements come with either fixed rates or variable rates. A fixed rate loan means that the interest rates will stay the same throughout the duration of the loan. While the cost and monthly payment stays consistent even in times of inflation with fixed rate loans, these types of loans typically cost more over time. A variable rate loan is a loan agreement in which a loan has interest rates that can adjust based on inflation. This type of loan greatly protects lenders, but can sometimes be volatile for borrowers, particularly in times of high inflation. When this happens, many turn to various secured loans, such as a car title loan, for their stability.

Even central banks and institutions play a role in inflation and loans. By controlling the money supply and setting the industry-norm of interest rates, central banks play a role in managing inflation. Central banks can even play a role in targeting specific inflation rates to stabilize the economy, thereby making them a key player in the loan-inflation process and relationship.

Inflation can greatly influence the dynamics of a loan and the many key players in the process. Through careful financial planning and budgeting, you can help to guard yourself from the turbulence of inflation, and set yourself up for overall financial success.