How Inflation Affects Interest Rates and Your Finances
By Daily Dosh | January 22, 2008
Inflation is what makes your money of today worth less tomorrow. Borrowers find borrowing money more attractive but it’s less attractive for lenders. This is why lenders raise their interest rates because they know that the dollars people pay next month are worth less than the money they loan today.
This turns into a vicious cycle. When prices rise, people and businesses tend to borrow more so that they can afford all the things the want to buy, whether it be cars, holidays or home improvements. This is turn causes interest rates to rise even more due to increased demand in borrowing money.
Inflation is primarily caused by governments. It may be because of borrowing themselves, printing more currency, deficit spending or giving out more credit. There isn’t much that you can do as an individual to change this.
However if you are wanting to borrow money, there is plenty you can do when trying to understand what is happening. Governments can’t keep increasing inflation as it would get to the point where there would be large demands for something to be done. When something does have to be done, this normally involves closing down the spigot or just slowing down the actions detailed above.
These actions affect how you borrow money, just like inflation. Deflation lowers rates which makes borrowing more attractive. However this causes the dollars to be worth less than they are tomorrow. Basically this means that your money is worth more tomorrow if you save and invest, than they are today.
If you are looking to borrow it’s a case of making a calculated guess as to whether inflation or deflation is going to occur. It sounds rather complicated but there are ways for the laymen to understand.
There’s no exact method set in stone but there are indicators to look out for and anyone can do this. In times gone by people used to look at the gold and silver markets, however the dollar isn’t linked to hard commodities anymore.
Because oil is such an important commodity which is linked to the production of so many products, increased oil prices means that inflation is more likely. If you notice that oil prices are set to increase or decrease in the future, you’ll have an idea of inflation.
Bond option prices are also a good signal. Professional money managers bet on whether interest rates will change considerably over the next year or two. This can be a slightly more tricky relationship to understand so it would be a good idea to ask a specialist.
Remember, the dollar today measures the costs of services and goods you buy today. But when you borrow money, those dollars are being spent today but paid back in the future. The value of the dollar when you pay back your loan reflects the true cost.