Is Inflation a debtors’ best friend?

Inflation is defined as the rise in general prices of goods and services over time.

Inflation erodes the value of a currency over time. Or put more simply in an inflationary environment a dollar today will buy you more of a good or service than the same dollar will buy you in a years time. So over time the value of the dollar in your pocket is worth less and less.

Inflation has been portrayed as the great bogeyman of the world economy. In Europe following the Great depression and hyperinflation in Germany the Nazis came to power. It wasn’t the only reason for the rise of the Nazis but it was a very significant contributing factor. For more on this read this Wikipedia link.

Ok history lesson over let’s get back on topic. We’ve established that inflation is seen as the biggest threat to the world economy. But does that mean that inflation is bad for everyone? Not necessarily. There are people who can gain from inflation. The people who gain the most are people in debt.

Sure you are paying more for your groceries and gasoline but let’s imagine the situation where you have a lot of debt – student debt, credit card debt, personal loans. When inflation is on the rise you benefit as the amount of money you owe is less over time. Inflation erodes the value of money. Inflation is eroding the value of the money that you owe so in theory you owe less.

Hey whoooah easy tiger I’m not finished yet. Before you break out the champagne there are a few criteria that must exist in order for inflation to eat into your debt.

First off to really see the benefits of inflation you to need to have your debt at a fixed rate of interest. The reason for this is because as a general rule of thumb governments and central banks raise interest rates to combat inflation. If the interest on your debt is at a variable or floating rate then you are going to feel pain as the interest rates will increase your repayments. If your debt is at a fixed rate then you need not worry about the rising interest rates and you can relax as inflation erodes the value of your debt.

Secondly to see even more benefits from inflation you need to be in a job or position where you can negotiate a pay rise to match the increase in the cost of living.

If you can negotiate a pay rise of say 4% and inflation is currently at 3% then that is a net gain to you of 1%. It is this additional 1% that can then be used to pay down your debt. Better still if you have fixed the interest on your debt then your additional 1% will go even further.

However even for debtors inflation is a double edged sword

While the scenario outlined above is quite positive for debtors the reality may be somewhat different. The view I have presented is simplistic. There is a reason why inflation is seen as a bogeyman for the economy. As things get more expensive – oil, gas, food – businesses can struggle. When employees start demanding more pay increases the businesses can struggle further still. Eventually a lot of companies go out of business and a lot of people lose their jobs.

So you see while inflation can help the debtor who has fixed their interest rates the chances are that their may be a risk to jobs. So while you may think Inflation is a great thing from a simple erosion of debt point of view be wary that it is not also eroding your job. No matter how bad your debt is at least if you have a job or an income there is more hope than if you don’t have any income at all.