I’ve been talking a fair bit about inflation lately, I’ll put a link to those podcasts at the bottom.
When inflation gets as high as it has, looking at real effect on your finances becomes way more important.
Let’s talk about debt first, what does a real cost of borrowing mean? Put simply, inflation acts as a negative to your interest rate. If we have an inflation rate of 8%, and you have an interest rate of 4%, then your real cost of borrowing is -4% (4%-8%). That doesn’t mean you don’t have to pay any interest, you still need to make your payments and there’s still the drag on your cash flow.
What is happening is that because inflation devalues money, it’s devaluing your debt as well. All things being equal, if your wages, value of your home, general prices, rise similarly to inflation, then your debt doesn’t increase, so though you’re paying interest, your debt is devaluing faster then the cost of interest.
This only has a positive effect on your net worth if you have an appreciating asset. I will also say that housing is not always an appreciating asset, the housing market can be quite volatile.. So though this devaluing effect will still happen to debts like a car loan, you shouldn’t go buy more car then you can afford because of this. Always keep within your means, and do what’s best for you.
This has a similar effect on investments, only in the opposite direction for your net worth. inflation still acts as a negative against the return of your portfolio, this is what a real rate of return means. a 10% annual return, which is incredibly good, when inflation is running at 8% is only a 2% real rate of return (10%-8%). So on a spending power basis, you could only buy 2% more with the sum of your portfolio this year compared to last, even though the dollar value has increased by 10%. Inflation acts as a drag against performance. When we’re in a situation as we are now where markets are volatile, and trending downwards, combined with inflation, real returns are substantially negative.
This doesn’t mean that in high inflationary environments you should take on more debt, the solution to high inflation is to raise interest rates. when inflation comes down to a lower level, interest rates aren’t going to perfectly move with inflation, and you can end up locking in a higher interest rate to some of your debt, which if you took it on for no productive purpose is still going to hurt you.
It can be difficult as well to want to stay invested, however your investment portfolio will have more capability to keep up with inflation over the long run, especially considering that high interest savings accounts and guaranteed deposits have a low enough return to guarantee a negative return on a real basis. Companies can reprice their services and goods, this gives them some ability to weather inflationary periods.
If you’d like to hear more about dealing with inflation, I’ve published two podcasts dealing with inflation, one on budgeting and planning for inflation, and the other on the effect inflation has on your investment portfolio.
https://anchor.fm/letstalkaboutitfinance/episodes/Planning-for-Inflation-e1kvoqt https://anchor.fm/letstalkaboutitfinance/episodes/Planning-for-Inflation-e1kvoqt