Inflation and interest rates are two important economic concepts that are constantly in the news. But what exactly do they mean? And how does inflation affect interest rates?
In this post, we'll take a closer look at these two concepts and how they interact. By understanding inflation and interest rates, you'll be better equipped to make informed financial decisions. So, let's get started!
What is inflation?
Before we dive into the burning question "How does inflation affect interest rates," let's discuss exactly what inflation is first. Inflation is the general increase in the prices of goods and services over time. It’s the reason why an item that costs $1 in 1922 now costs $16.73 in 2022. And it’s also why that same item could run you $58 in 2072.
Inflation is known as retirement's "silent killer" because it creeps up over time, slowly eroding the value of your money. Inflation also impacts businesses. And there are all types of factors that influence this — changes in monetary policy, higher production costs, or rising demand for goods and services.
In the U.S., 2% is a “normal” inflation rate. It’s what the Federal Reserve strives for each year. But it doesn’t always happen.
Take February 2022, for example. Inflation hit 7.5% — the highest jump we’ve seen in over 40 years.
This was primarily due to rising supply chain costs and worker shortages amidst the coronavirus pandemic. And if you were "adulting" during that time, then you most certainly felt the strain on everything from groceries and gas to electricity and housing.
What is an interest rate?
An interest rate is the price you pay for borrowing money (or the amount of return you earn on saving money). It's expressed as a percentage of the amount borrowed or saved.
For example, suppose you have a $1,000 credit card balance with a 20% annual percentage rate (APR). If you only made the minimum monthly payment, it'd take you almost five years to pay off your debt and you'd end up paying over $560 in interest for the money you borrowed.
Now, when you’re saving money, higher is always better because it means the bank is paying you more money. But when you’re borrowing money — say for a home, a new car, or a business venture — you want interest rates to be as low as possible because this saves you the most money over time.
When borrowing, you'll also want to note whether your loan has a fixed or variable interest rate. With a fixed-rate loan, your interest rate is locked in. So, you don't have to worry about paying more money if inflation rises. (Auto loans, mortgages, and student loans typically have fixed interest rates.)
However, if you have a variable interest rate loan, it can change at any time based on overall market rates. So, if you have a credit card or something similar where the rate changes from month to month, it has a variable interest rate.
How do interest rates affect inflation?
Okay, so how do interest rates affect inflation? When inflation rises, interest rates usually go up too.
This is typical because the government wants to encourage people to save money instead of spending it. And lenders want to be compensated for the higher risk of lending their money when prices are going up.
So, if you have a variable interest rate, you may see your rates go up too. And if you're shopping around for a fixed-rate loan, you may notice average rates getting higher the longer you compare options. (You'll see rates getting cheaper if inflation is dropping.)
However, there are other factors (besides inflation) that also affect interest rates, such as the economy and political conditions.
For instance, when the coronavirus hit the U.S. in March 2020, the Federal Reserve slashed interest rates to 0%. People were losing jobs. Everyone was afraid of the future. So, the Fed cut interest rates to almost nothing to make borrowing cheap.
How the Federal Reserve uses interest rates to control inflation
The Federal Reserve is the nation’s central bank. Among other things, it sets interest rates for borrowing and saving money.
When the Fed wants to increase the availability of money (i.e. stimulate economic growth), it lowers interest rates. This makes it cheaper to borrow money, which in turn encourages people and businesses to spend more.
Conversely, when the Fed wants to reduce the availability of money (i.e. cool down the economy), it raises interest rates. This makes borrowing more expensive, which in turn discourages people and businesses from spending as much.
The link between inflation and interest rates
Inflation is one of the factors that the Federal Reserve takes into account when setting interest rates.
When inflation is high, the Fed typically raises interest rates to discourage people and businesses from borrowing and spending too much money. This can help keep inflation in check.
Conversely, when inflation is low, the Fed may lower interest rates to encourage borrowing and spending. This can help boost the economy by increasing the demand for goods and services (which is exactly what happened at the start of the pandemic).
How does inflation affect interest rates as a borrower?
When inflation rises, interest rates on mortgages, credit cards, and loans usually follow suit. And as a borrower, this is bad because it means loans are much more expensive.
And as a result, you may pay higher interest on credit card debt or find it more difficult to afford that new car or home you’ve been eyeing.
Here's a big example of how inflation affects interest rates as a borrower...
The interest rate you pay on your mortgage is one of the most important factors in determining how much your monthly payments will be. And because most people borrow a large amount of money to buy a home, even a small change in the interest rate can have a big impact on your monthly payments.
For example, suppose you're thinking of buying a house for $350,000. You get a few quotes from lenders and find out interest rates are around 4% right now. Okay, cool.
Now, let's fast forward into the future six months. You're finally ready to take out a mortgage, but now rates have increased to 4.5%. It's only 0.5% higher than before. So, no big deal, right?
Here's the catch: over the life of your loan, you end up paying $36,000 more in interest with the 4.5% loan. That's a HUGE difference... even if it was only 0.5% higher. (You can use a site like mortgagecalculator.org to compare interest rates for loans side by side.)
How does inflation affect interest rates as a saver?
Okay, so what's the impact of inflation on interest rates when you're saving money?
We'll put it to you like this: When it comes to savings and investments, high inflation rates erode the value of money over time for savers and retirees. (Remember us calling it a "silent killer" earlier?) Here's why...
Let’s say you have $50,000 in a savings account earning 0.5% interest. If inflation is 3%, then the real value of your money (aka its purchasing power) is going down by 2.5% every year. In other words, even with interest, your money is shrinking and buying fewer goods as time passes.
Now, on the bright side, a high inflation rate means interest rates on savings accounts could also be on the rise. But even still, these interest rates are almost never enough to beat inflation, even in the best of circumstances.
How to protect yourself from the impact of inflation on interest rates
There are a few things you can do to protect yourself from the impact of inflation on interest rates:
Shop around for the best mortgage rate when you’re buying a home
If you’re a homeowner (or a soon-to-be homeowner) one of the best ways to shield yourself from inflation-related interest hikes is to compare rates from different lenders. (Some experts recommend getting rate quotes from at least five places.) And if you already have a mortgage but rates have decreased dramatically, consider refinancing.
Consider looking for a fixed-rate mortgage, so you never have to worry about your monthly payment rising with inflation. This is one of the biggest problems with variable-rate mortgages and balloon mortgages: your rates can jump at any time — even with interest spikes.
Invest for future you
Investing is one of the only ways to generate an average return that beats inflation, which is essential if you want to build real, long-lasting wealth for your future.
Yes, you want to keep your emergency fund and other short-term money in a savings account where it's easily accessible. But if you want a shot at beating inflation, you have to invest.
These investments could be mutual funds, ETFs, Treasury Inflation-Protected Securities (TIPS), you name it. The idea is to build a diversified portfolio that has an average return higher than the average inflation rate.
Deep breath, stay calm
It's almost impossible to turn on the TV and NOT hear some newscaster talking about how inflation is rising to new heights. The news is designed to make you anxious.
And one of the best ways to get through is to turn off the TV, take a deep breath, and remember that inflation is normal. Even in times where it's high, it always smooths back out.
The takeaway: How does inflation affect interest rates?
As you can see the impact of inflation on interest rates affects your finances personally. However, inflation is a fact of life, and it can have a significant impact on interest rates.
But by understanding how inflation works and taking a few simple steps to protect yourself, you can minimize the negative impact it has on your finances.
Remember to work towards investing to beat the effects of inflation on your money. Check out "Learn How Investing Works, Grow Your Money" to learn everything you need to know to build wealth!