Inflation and Debt: 5 Ways Inflation Makes Your Debts Easier and Harder to Pay Off

Inflation. You've undoubtedly heard that word buzzing around a lot lately. You might have noticed your grocery bill creeping up or the cost of filling up your car getting significantly more painful. Between May of 2021 and May of 2022, gas prices rose from $3.15 per gallon to $5.03. Have you thought about what this means for your debts? Inflation and debt are often tightly correlated. Inflation doesn't just stop at the supermarket; it also plays a pivotal role in how we handle our debts. Some debts become more challenging to pay, while others become easier.

Let's dive into the weird and interesting ways inflation impacts your journey to being debt-free.

1. Inflation and Debt: Your Debts Can Shrink (Sort of)

Imagine you borrowed $100 last year, and today, everything costs a bit more because of inflation. That $100 you owe? It's not as "heavy" as it was last year. This "trick" is a neat byproduct of high inflation - it can decrease the relative value of what you owe, especially if the debt is at a fixed interest rate. But before you break out the confetti, remember that this mainly applies to long-term debts like your 30-year mortgage or those student loans from way back.

To illustrate this, consider that the average home 30 years ago cost $144,000. Today, it costs over $500,000. A $144,000 debt would have felt relatively high in the mid-90s, but in today's dollars, $144,000 would be very inexpensive.

As long as your interest rate is lower than inflation, your debt effectively gets "cheaper" with each passing year. So, if you have a low-cost student loan or a low-rate mortgage, you may wish to hold off on paying down those debts during high inflation instead of paying down other variable-rate debts, like credit cards and home equity lines.

2. The Rising Tide of Interest Rates

Here's the catch to the upside discussed above - to fight inflation, the Fed must often hike interest rates. Over the past year, the Federal funds rate has increased by 5%.

If you've got debts with variable rates (think credit cards and some home loans), this is where things get tricky. Higher interest rates mean higher monthly payments, making it more challenging to clear those balances. It's like trying to run uphill. The faster you go, the steeper it gets.

These increases may not seem like much in relative terms, but if you barely made your minimum payments before, you may find yourself suddenly without enough money at the end of each month to pay all your bills.

At a 20% interest rate, you could pay a $10,000 credit card balance in 5 years with $265 monthly. At a 25% interest rate, that amount jumps to $294, approximately $350 more per year than you'll pay in interest.

Fixed-rate debts become cheaper with higher inflation. Variable rates become more expensive. During periods of high inflation, focus more on paying off those more expensive debts first.

Therefore, in this high-inflation environment, prioritize paying your credit cards ASAP. Inflation and debt, especially credit card debt, don't mix well.

3. The Salary Slow Dance

We all wish our paychecks would play catch up with rising prices, right? Unfortunately, wage growth often moves at a snail's pace compared to inflation. If you're trying to juggle increased living costs without a bump in your salary, squirreling away money to pay off debts gets a lot tougher. It's like trying to fill a bucket with a hole in the bottom - a frustrating endeavor.

And unfortunately, the economy continues to face significant disruptions, including the continuing disruptive force of AI. So, job hopping becomes significantly more challenging.

If you have stagnating wages and rising debt costs, you may need to consider a side hustle to maintain your momentum and clear those debts off faster.

4. The Vanishing Savings Act

Savings and emergency funds are our financial safety nets. We've already discussed the importance of building a powerful emergency funds buffer.

But here's the twist: inflation can shrink your savings' value in buying power, even if the interest rate is higher. You'll feel like you're getting more money on your savings, but it still may not keep pace with inflation.

An emergency funds buffer is still essential even in a high-inflation environment. Do not make the mistake of thinking that holding onto some cash is worthless.

As such, when life throws a curveball (and it inevitably will), and you need to dip into those funds, you might find they don't stretch as far as you'd hoped. Less in the kitty for emergencies means less to chip away at those debts. Or, worse, you might need to put those added expenses back on your credit cards, putting you further into the hole.

5. Inflation and Debt Create an Investment Conundrum

Paying off debt is great, but what about using some of that money to invest, especially during high inflation? There's a whole debate here. Some investments, like certain stocks or real estate, have the potential to outpace inflation. So, in a way, rather than losing money in a savings account, it makes logical sense to invest it in these instruments that can grow your wealth. On the other hand, investing in these assets will risk your capital - and if you lose money while trying to pay down debt, you've just made paying everything down that much harder.

It's about striking a balance - you absolutely must pay down debt, but you should explore opportunities to grow your wealth. It's not an easy decision, and it varies from person to person, depending on your situation and how much risk you're comfortable taking on.

Inflation and Debt: Two Steps Forward, One Step Back

So, there you have it - the rollercoaster ride of dealing with inflation and debt. It's a mix of good news and challenges, and paying down debt in a high-inflation environment often feels like a proverbial "two steps forward, one step back" task.

The key takeaway? Be agile and informed. Keep an eye on how inflation and interest rates are moving. Do not ignore rate movements if you have either fixed-rate or variable-rate debt. If necessary, don't hesitate to get advice from financial pros. They can help you navigate these wavy financial waters and reach the shore of debt freedom!