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Handling Debt - Inflation and Interest Rates


You may be asking yourself what inflation has to do with handling debt or borrowing money. Simply put, inflation makes the money you earn tomorrow worth less than the money you made today. That makes borrowing more attractive to the borrowers, but lending less attractive to lenders.

To compensate, in times of higher inflation, lenders raise the interest rates they charge, since (among other things) they too know that the dollars they will be repaid next month will be worth less than the dollars they lend out today.

And so the vicious cycle starts. As prices increase, people find themselves needing to borrow more in order to buy the things they want, such as cars and home improvements. Since there is now more demand for borrowed money, interest rates tend to rise even further. A limited supply of anything tends to raise prices. In this case, the greater demand for money means the cost of borrowing goes up.

Government actions definitely have a impact on anyone looking to borrow money. They can cause inflation through their own high borrowing, deficit spending, or by actually printing more currency. Individuals can't do much to change the system, but each person can recognize the causes and advocate sound policies.

Governments don't continually increase inflation. If they did, as happened in the late 1970s, for example, interest rates would eventually reach a point where the loud demands to 'do something' are heard. When the government 'does something' it invariably means shutting off the money tap (supply). This reverses or at least slows down the cycle.

On the opposite side of inflation, deflation may lower interest rates and encourage more borrowing. Keep in mind that in a deflationary market, dollars borrowed today are worth less than they would be tomorrow. So you are repaying a loan with dollars that would be worth more tomorrow if you held onto them by saving or investing than they are today.

So what does all this mean to you? When you consider borrowing money, try to make a guess just as the banks do, about which way inflationary or deflationary pressures are likely to go. That's a tough job even for the professional economists, so how can a laymen be expected to do that with any success?

There are no absolute formulas but there are some indicators that are available to anyone. Gold and silver used to be good indicators, but that is no longer entirely true, since the dollar is no longer tied to any hard commodity.

Oil is a very basic commodity that is tied to the production of so many other things. As the price of oil rises, inflation is likely to heat up, at least to some degree. So look at the price of oil options to see whether prices are expected to be higher or lower in the future.

The price of bond options going up is also an indicator. In this case it suggests that professional money managers are betting interest rates will change sharply over the coming year or two. The relationship is a little complicated so you would do well to consult a specialist.

Just keep in mind that a dollar today is a measure of the cost of goods and services today, just as a dollar tomorrow is a measure of that cost tomorrow. But when borrowing money, you're buying dollars today to spend today, but will pay them back in the future. How much those dollars are worth when you pay them back is a measure of what that loan will actually cost you.

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