Inflation causes money to lose value over time. Over time, prices for goods and services tend to increase. This has a major impact on the global economy.
And because inflation impacts the purchasing power of money, it also impacts borrowers and lenders.
Both parties benefit from inflation in some ways. Borrowers with fixed-rate loans can benefit from repaying debt with less valuable cash while lenders benefit from raising rates on variable-rate loans. Lenders might also benefit from increased demand for loans as people need more cash to purchase necessities.
Who Benefits From Inflation: Borrowers or Lenders?
In general, people who have already borrowed money at fixed rates benefit from higher levels of inflation, while lenders benefit from inflation when offering new loans or adjusting variable interest rates on existing credit products.
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How Inflation Helps Borrowers
Inflation causes money to lose value over time. That’s a good thing for people who borrow money at fixed rates during periods of low inflation.
Lower Real Borrowing Costs
The primary benefit that borrowers see from inflation is that it reduces the real value of the money they use to repay the lender. In general, $1 today is worth more than $1 tomorrow or a year from now, so it’s better to have money available now even if you have to pay it back later.
Interest rates help compensate for this. If you borrow $100 at 5% interest rate and a term of one year, it costs $105 to repay your debt: $100 in principal and $5 in interest. The lender is betting that that $5 in interest will make up for the purchasing power lost to inflation.
Nominal Value vs. Real Value of Credit
Nominal and real interest rates help us think about this. Nominal rates describe the number of dollars you have to give a lender to repay a debt while real rates look at purchasing power rather than the number of dollars. You can calculate real rates by subtracting inflation from the nominal interest rate of a loan.
Imagine a loan for $10,000 at a fixed rate of 4% interest. You’re expected to repay the loan in full at the end of the year. You’d make a payment of $10,400 to repay the debt.
If inflation is 5%, the value of the dollar drops by 5% over the course of the year. That means that you receive $10,000 in purchasing power at the start of the year but only repay $9,900 in purchasing power to cover the debt. You received more purchasing power than you repayed.
Put another way, the real interest rate of that loan was -1%.
Keep in mind that for variable rate loans, the rate will likely rise with inflation, reducing the benefit for borrowers.
How Inflation Helps Lenders
In general, lenders benefit from inflation when they issue new loans because inflation increases interest rates and demand for loans.
Higher Interest Rates for New Credit
Inflation has a direct influence on real interest rates, but it also plays a major role in determining nominal interest rates on loans and lines of credit. The higher the nominal interest rate on the money they lend out, the more money lenders make, all else being equal.
Central banks like the Federal Reserve (the Fed) typically have a target for the rate of inflation in an economy. They believe that having a modest inflation rate is good monetary policy because it encourages consumer spending.
In contrast, they believe high inflation and deflation — negative inflation, where money gains value over time — are both bad for the economy.
True deflation is uncommon, but periods of high inflation occur regularly. When inflation rises significantly, the Fed generally takes aggressive steps to bring it down.
The Fed’s most powerful inflation-fighting tool is its benchmark interest rate, known as the Federal Funds Rate. When inflation spikes, the Fed raises the Federal Funds Rate, raising borrowing costs for U.S.-based banks and everyone who borrows from them.
The interest rate for everything from mortgages to credit cards is impacted by these benchmark rates. That means that amid higher inflation, lenders can demand higher interest rates. They can increase the interest rates on existing variable-rate loans like credit cards and adjustable-rate mortgages, allowing them to collect more interest.
For fixed-rate loans, like fixed-rate mortgages and personal loans, they only get this benefit on newly-issued loans because existing loans have set rates.
More Income from Revolving Credit
One of the places where lenders see the most benefit from rising rates is on revolving credit balances, such as credit cards and lines of credit.
Revolving credit accounts usually have variable interest rates, which means that lenders can increase those rates at will. As inflation rises, the rates on these products typically rise too, automatically applying to any outstanding and future balance. This allows lenders to increase their income from customers already carrying a balance.
Additionally, borrowers with revolving credit can add to their balance without needing to apply for new loans. Underwriting and funding new loans takes work for lenders. Allowing customers to add to their revolving balances is faster and easier. That means lenders get the benefit of rising inflation and interest rates right away.
Increased Demand for Credit
For the average consumer, the most noticeable result of inflation is higher prices for food, gasoline, rent, electricity, and other necessities. One of the most common measures of inflation is the Consumer Price Index (CPI), which measures the price changes within a broad basket of consumer goods.
When consumer prices rise, people spend down their savings, then rely on credit to get by. This means higher credit card balances and more applications for personal loans, home equity lines, and other types of credit.
Borrowers May Take Longer to Repay Debt
As the value of money decreases, borrowers may need to spend more on essentials and less on saving or repaying debts.
So long as debtors keep making their monthly payments, lenders benefit from those borrowers taking longer to pay off their loans. A borrower who repays a loan in full before its due date deprives the lender of at least some interest. The lender gets more from the borrower who makes only the minimum payment each month.
Verdict: Do Borrowers or Lenders Benefit From Inflation?
Ultimately, both borrowers and lenders benefit from inflation. What really matters is the timing of the loan.
Borrowers who have already borrowed money benefit from rising inflation, especially if it is unexpected inflation and they have fixed-rate loans. While variable-rate loans can see rates rise when inflation does, fixed-rate loans keep the same interest rate.
When inflation rises above the fixed rate on a loan, the borrower enjoys a negative real interest rate. In other words, they’re paying back money that’s worth less than they borrowed.
Meanwhile, though lenders lose money on existing fixed-rate loans when inflation rises, they reap the benefits of inflation on new fixed-rate loans and existing variable-rate credit products.
What’s more, inflation increases borrowing demand from folks who need extra cash to deal with the rising price of goods.
Inflation has many benefits for both borrowers and lenders. Most economists believe that a low but steady, rate of inflation is good for the economy.
However, inflation also has its negatives. It makes goods cost more money and wages may not keep up with inflation, leading to an effective loss in income for many workers. Because of its impacts on all areas of the economy, informed consumers need a clear understanding of how inflation works — and how it affects their personal finances.