Money & You

Does inflation help with debt?

July 12, 2023

Cost of living and inflation is pretty stink right now. Everything is more expensive, even the essentials, and interest rates are creeping up too, taking more money out of your pocket. You don't have to go far to find some news saying how bad things have gotten - but did you know that inflation can actually be helpful if you're in debt? It's a knife that cuts both ways - here's how it might be cutting in your favour.

About inflation and how it affects you

Basically, inflation is a measure of how much your spending power has reduced over the last year, expressed as a percentage. Ideally, the Reserve Bank tries to keep it between 2% and 3% per year. This means that, in perfect circumstances, $100 worth of groceries this year will cost $103 of groceries next year. Inflation is a fact of life (and economics!), but economists do try to keep it under control. This is a big part of what the Official Cash Rate is all about - but for this convo, that's not important.

What *is* important is how inflation affects you. Take that grocery example - by next year, you won't be able to buy as many groceries with the same amount of money. Not ideal, especially when inflation is high, like it has been over the last year (7.2% at the time of writing). But it also means that the value of your *debt* is less too!After a year of inflation of 3%, money is worth less. But debt is *also* worth 3% less. Does this mean that your debt goes down by 3% each year?

Not quite. Your debt doesn't disappear, but it does get relatively easier to pay off when your income increases at the same rate of inflation (which it should).

Example

Someone has $1,000 of debt and $50 a week of income going to repayments. It would take 20 weeks to pay that off.Now let's pretend that person had an interest-free period of a year, during which there was 3% inflation and they were able to increase their income by 3% to match.

Their debt is still $1,000, but now they have $51.50 of income going to repayments. Now it would take 19.5 weeks to pay off.

That may not sound like much, but now apply that to long-term debts like mortgages. The difference on $500k of debt after 30 years of 3% inflation nibbling away at it (as well as regular repayments) can make a huge difference. The key is that income must increase at the same rate as inflation - otherwise you're in the same position as before.

Summary

Phew, a lot of maths there. If you're looking for the short version, here it is: inflation makes life more expensive, but it can make debt less expensive too. You just have to ensure that your income increases at the same rate of inflation each year - about 3%p.a. on average. Just like compound interest, inflation can be a friend or a foe. The key is knowing how to make that knife cut the way you want it to!

So - time for a salary review?

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