How Inflation Affects Your Interest Rate

You interest rate is only high or low in comparison to other factors on the market, and one of those factors is the rate of inflation. Inflation is a measure of the value of a dollar of U.S. currency over time. It is nearly impossible to estimate inflation in advance since it responds to many market factors. However, in the long run, inflation tends to go up over time. When inflation swings dramatically in one direction or another, your loans may become more competitive or less competitive on the market. 

Variable Rate Loans and Inflation

Variable rate loans are often used to compensate for changes in inflation. When a lender issues a loan, the lender is making a bet about the rate of inflation over the life of the loan. If inflation does not react in the way the lender expects, then the lender may not make enough profit. Lenders wary of this possibility will use variable rate loans to protect themselves against loss.

Variable rate loans will see higher interest rates when inflation is higher. Unfortunately, interest rates rarely drop when inflation goes back down. To protect yourself against high adjustable rates, set a limit on how high your rate can climb. You can set the limit as a certain amount over your initial interest or even a percentage difference over the national prime rate. The national prime rate will adjust with inflation, and this should protect both you and the lender.

Fixed Rate Loans and High Inflation

When you have a fixed rate loan, your loan becomes more competitive if the value of the dollar decreases. Consider this example: your auto loan charges a 6.25% fixed interest rate, resulting in a monthly payment of $225. When you take the loan, the national prime rate is 5%. Inflation goes up, so the Federal Reserve adjusts the prime rate to 6% over two years. Now, your loan is only .25% over the national prime.

Not only is your loan competitive on the market, you are actually spending a little less today than you did a year ago for the loan. The same $225 has a lower value on the market, and you can get less for that sum. Your income will most likely increase to compensate for inflation, so the same $225 should be a lower percentage of your monthly income. 

Fixed Rate Loans and Low Inflation

On the contrary, if the rate of inflation is low or decreases while your loan is active, that same $225 is actually a larger portion of your spendable income over time. The lender makes more profit because the national prime rate goes down, say to 4.5%, and you are not paying 2.25% over the prime average. If you approached the same lender for the very same loan today, you would have gotten a lower interest rate. 

In this case, you may want to consider refinancing the loan to bring it more current with national averages. Refinancing to a current rate will save you money, but it can also be difficult to do depending on your lender.

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