How inflation can benefit borrowers—not bankers

Headlines of rising inflation are usually met with groans. Because inflation naturally means the value of each dollar in our pocket has decreased in worth. But did you ever think the same applies for the value of the debt we carry? Suddenly, inflation isn’t such bad news. In fact, looking closer, inflation benefits borrowers.

There are several ways inflation can benefit borrowers:

1. Nominal loan value remains while its real value decreases
2. Improved ability repay mortgage
3. Asset values appreciate (debt balances don’t)
4. Positive economic growth
5. Tax-free advantages

You might’ve looked back at the nineties and shaken your head at the price of a beer or cost of fuel per litre. Similarly, with mortgages and loans reaching terms of up to 30 years, a borrower’s original loan amount might look paltry in three decades’ time. It’s just one of the ways inflation can benefit borrowers over bankers. There are many more and it’s mainly thanks to real vs nominal values.

How can inflation benefit borrowers?

1. Nominal value remains while real value decreases

This is what we’re here to talk about. You take out a loan of a specific balance, and while the amount you owe stays the same in nominal terms (aside from any amounts you pay down), its real value (adjusted for inflation) decreases over time.

Because prices rise and the value of money decreases, the amount you owe the bank effectively becomes smaller in real terms.

2. Improved ability to repay

If the income used to repay your borrowings increases in line with inflation, your ability to repay debt will improve. That’s because not only loan balances remain the same in nominal terms, but so do the repayments associated with them.

For commercial property borrowers, rental income escalations are often reviewed and increased in line with the Consumer Price Index (a measurement of household inflation). Assuming that that rental income goes directly to repaying borrowings, the commercial borrower has greater repayment power, because repayments don’t see such inflation-based increases. (We’ll talk about interest rates soon.)

3. Your asset value appreciates—your debt balance doesn’t

One safeguard against inflation? Invest wisely.

Those with residential properties or commercial assets know this well, as their investment not only increases in value over time (as per historical records) but can also provide cash flow to bolster their overall return.

Meanwhile, the debt they took out to fund these property purchases sees no value appreciation.

4. A reflection of economic growth

Ever stopped to think what inflation truly reflects? Inflation often only occurs in periods of economic growth, where wages and prices are rising. So, if your income (and your investment’s income) outpaces the increase in interest rates, you’ll still likely find yourself in a better financial position, in real terms.

5. Tax-free benefits

If you’ve digested the above, then you’re clearly interested in how inflation positively affects your borrowings. Well, even more good news. Those benefits are tax-free.

Unlike an increase in salary or rental income, which is of course taxed—and even has the potential to push you into a higher tax bracket—a reduction in your debt’s real value is gifted to you without any tax implications.

But what about interest rate rises?

As we all know, the Reserve Bank of Australia (RBA) commonly tackles rising inflation with a single tool: interest rate rises.

When the inflation rate rises above the RBA’s target (in Australia, the inflation target has almost always been around 2 per cent to 3 per cent), they’ll typically increase the cash rate to slow the economy down and return inflation to preferred levels.

So, if inflation rises bring about higher interest rates, doesn’t that balance out the good and bad? Won’t the cost of my borrowings increase, too?

Yes, they likely will. But it’s not all bad news.

How can inflation still benefit borrowers after rate hikes?

Fixed rate loans protect against rate hikes

Of course, fixing your rate prior to rate increases will secure a more appetising interest rate in high interest rate environments. Borrowers with long-term debt can then enjoy the real value reduction of their loan balance, with a shield against rate hikes for their agreed fixed rate term.

(There are of course many factors involved in knowing whether a fixed rate is the right avenue for your own borrowings. So, consider them all with your financial planner or accountant.)

Rate increases lag behind inflation

Okay, we’re now getting into the weeds. But it’s true that even when the RBA increases the cash rate, there’s often a lag between the onset of inflation and the decision to hike rates. If inflation is at 6 per cent and the central bank increases the cash rate to 4 per cent, the real interest rate is still negative 2 per cent. Once again, borrowers are effectively paying less, in real terms.

Knowledge is power, inflation is beneficial

Inflation mightn’t save you tens of thousands of dollars in repayments overnight. But the notion that rising inflation isn’t all bad news—especially when the reserve bank hikes rates as a result of it—should empower borrowers. It’s another gift for wisely investing your capital and appropriately leveraging to facilitate that investment.

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