How Inflation Affects Loan Interest Rates

Posted April 22nd, 2019

If you’re doing your weekly shopping at the grocery store and you notice that prices for meat, vegetables, and other consumer goods have all gone up, this can be best explained by a term called inflation. But what does it mean for your loan interest rates?

In economics, it’s common practice to link inflation and interest rates due to their inverse correlation: when interest rates are low, more spending power is available for the public, causing growth in the economy and a rise in inflation. On the other hand, when interest rates increase, the population tends to save more due to higher returns. This leads to less disposable income, slowing down inflation and the economy as a result. All of this means that a typical family has to adjust their budget depending on the changes in inflation and interest rates. For example, imagine that the overall price of goods in your local grocery increased by 5%. If you allocate $500 for monthly grocery shopping, then you would need to allocate $525 the next month for the exact same items. There may have been varying increases in the prices of goods, and some prices may have even decreased, but the family will likely still have to include the additional $25 in their budget.

Here in the United States, interest rates are based on something called the federal funds rate, which is determined by the Federal Reserve based on the expected inflation for the year. You might remember how the last peak of inflation was in July 2018, when The Economist claims that consumer-price inflation rose to 2.9% — a figure that was well above the Fed-estimated 2%.

When an unexpected rise in prices like this occurs, it's more than just the grocery store that you have to prepare for, as it can also have unwanted effects on mortgage payments. An increase in inflation rates tends to push up long-term bond yields, which mortgage rates normally follow. The government also tends to raise interest rates to curb unexpected inflation. These, in turn, lead to a reduction in house-buying power and hikes up the mortgage interest rates you will have to pay. This is true for those planning on buying a home, as well as those whose current mortgage rates are adjustable — that is, a type of interest rate that isn’t fixed over the duration of the loan.

Of course, these effects of inflation on your interest rates are clear during what economists would describe as ceteris paribus, or when all things are equal. But the reality is that economic factors are rarely static, and inflation often interacts with a variety of other things that can affect your loan interest rates. This makes all these economic and financial matters a little confusing, especially if this is your first major purchase. If that's the case for you, it’s important to understand that you are far from alone. In fact, Maryville University’s industry outlook for finance professionals shows how the demand for expertise in this niche is set to grow by 30% all the way until 2024. That's because financial analysts and advisors continue to play a crucial role in making concepts like these more intelligible for the public and pointing us towards better financial choices.

But no matter how daunting it may be, it can’t all be left in the hands of financial advisors. A little research here and there can definitely help you make sound financial decisions. When making big purchases like buying a house, for instance, you might want to follow some of our tips when choosing a good mortgage lender. It is definitely not easy to achieve financial literacy, but in trying to do so, you may just find yourself beginning to spend money at the right times and in the right places.

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