“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”
“I don’t mind going back to daylight saving time. With inflation, the hour will be the only thing I’ve saved all year.”
Have you, your parents, or your grandparents complained about the days when you could buy a Coke for a nickel and a gallon of gas for a quarter? You can’t buy that cheaply anymore, unless you’ve built a time machine, and if you have, I’d like to have a private discussion with you! Instead, prices have gone up and, for the most part, will continue to go up because of inflation.
There are a couple of generally accepted theories for why inflation occurs. The first is due to the increasing cost of labor. Wages rise over time, as people expect to be paid more this year for work than they did last year, particularly if they have improved at their jobs. As a result, producers who use that labor have to pass on the increasing costs, and they do so by raising prices. The rise in prices causes consumers to demand higher wages, and everyone gets caught in a never-ending inflationary cycle. The second theorized cause for inflation is when aggregate demand by consumers is greater than an economy’s ability to meet that demand. Think about filet mignon versus ground chuck. Many people desire filet mignon, and given the choice, would probably choose it over ground chuck. As a result, the producers of filet mignon can charge a higher price because of the demand. When demand exceeds supply, suppliers can raise prices, causing price inflation.
Whatever the cause of inflation, the reality of it is that a dollar buys more today than it will in the future. We’ll probably one day long for the days of $1.00 Cokes and $4 a gallon gas, remembering how cheap it was.
There are times when inflation is good, though.
One of them is when you have a fixed price debt, like a fixed rate mortgage or a student loan where you have locked in the interest rate. The amount you pay every month is the same, regardless of if it is the first month or the last month. However, over time, the purchasing power of that payment amount will decrease. Let’s imagine that you had a loan in 1980, when the cost of Cokes from a vending machine was a quarter. Your payment was $500 a month. That would buy you 2,000 Cokes a month – and probably rot your teeth out and cause all sorts of gastric problems! However, in 2010, a Coke from a vending machine was about a dollar, meaning that your same loan payment, $500, would only buy 500 Cokes. The relative amount of what that payment would buy decreased over time.
If you’re working and get wage increases over time, this is a good deal. Your wages generally will increase to match inflation, so the payment becomes a smaller portion of your overall income as time passes. According to the Social Security Administration, average wages in 1980 were $12,513.46, and in 2010, they were $41,673.83. Thus, your $500 monthly payment in 1980 represented 47.9% of your total annual income if you received average wages, but it was 14.4% of your income in 2010.
With interest rates at record lows and with the Federal Reserve Bank hinting at interest rate hikes in either 2013 or 2014, if you are going to get a loan – student loan or a mortgage – at a fixed interest rate, it’s probably the best time to do so, as the real value – the value of the loan adjusted for inflation – will decrease over time because of rising interest rates.
Don’t take this to mean that I support massive amounts of debt. I do not think there’s such a thing as “good debt.” I am very risk averse and realize that I value the peace of mind of not having debt payments over the potential gain to be had for borrowing money so cheaply. However, if you must get a loan, now is probably the best time you’ll ever see for doing so because of how inflation will affect your fixed rate real values over time.
There is one problem to the refinancing approach – if you use the refinance to extend the term of your loan. A lot of people will refinance when rates drop, but will get a new 30 year loan. Instead, go for the lowest possible term that you can afford; you do not want to retire in debt!