Inflation’s Effect on Interest Rates

March 22, 2009 by  
Filed under Debt Handling

Inflation can seem like the big, bad wolf when it comes to the value of future dollars that you’ve worked so hard to earn and save over the years. This is why many of us turn to borrowing, especially at low interest rates. Interest rates are charged by lenders to compensate for the use of their money, knowing that each month’s payment represents less value than the month prior.

When prices of consumer items rise, including housing and automobiles, many have no choice but to borrow in order to buy them. In return, interest rates rise even more with increased demand. These interest charges are simply the cost of borrowing money.

Inflation and changing values of the dollar are directly affected by the policies practiced in our governments. If they borrow aggressively from other countries, spend when they can’t afford it and start printing more money, the value of the dollar greatly declines. However, there isn’t much that citizens can do to change this vicious cycle, other than remain aware of what actions their government may be taking that will directly affect household borrowing and budgets in the future.

Conversely, the government also has the ability to deflate the economy and increase the value of a dollar. This action requires reduced spending and lowering interest rates to make borrowing a more sound option. However, these dollars will continue to rise in value in this situation; this means that your debt payments are worth more if you hang onto these dollars for future use in this type of economic environment.

Considering possible changes in the economic climate during the life of a loan is beneficial to both a borrower and a lender. This consideration helps to determine the proper interest rate to both implement and seek out to better everyone’s situation.

In the past, many looked to the changing value of gold or silver as an indication of what the value of the dollar was doing. However, this is no longer necessarily true.

Today, commodities such as oil and bond options are better indicators of what interest rates are likely to do in the near future. Oil is directly related to many production industries, and rising rates will lend a clue to inflation.

Bond options will increase in price when professional money managers invest in them assuming that interest rates will rise in the near future. These indicators can help you to determine if it is best to borrow today or wait a while – or better yet, just save your money, earn the interest on it, and pay cash for whatever it is you want or need.

Considering what a loan will actually cost you in the long run requires taking inflation and/or deflation into account. If you’re borrowing money, you want to spend it today. However, you’re also planning on paying it back in the future, and you need to consider the possible change in the value and worth of the dollar. Taking these values into account will help you make a sound decision when seeking a loan and determining if it is absolutely necessary.

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