We have talked about the effects of inflation on the value of the dollar before. Now how does this translate to our everyday lives? One key thing to understand about inflation is how it affects debts that you may owe or that someone owes to you. Understanding the basics will not only help you understand market dynamics but it will also help you make sound and savvy financial decisions when it comes to paying off your debt!
People have all kinds of debt such as student loan debt, credit card debt, auto loan debt, residential mortgage debt, et cetera. Generally speaking it is a great thing for people to pay off all their debts and live a debt free life. However, if you understand inflation, debt, and opportunity cost, you will sometimes find that paying off debt doesn’t make financial sense. That’s right! It may cost you to pay off your debt in some cases. For example, if you had locked in a fixed rate of 3.5% on a loan for $30,000 sometime in your past and inflation was running at 4% then you would not want to pay off this debt as long as inflation was higher than your fixed rate. Let’s examine why this is the case.
If you had $30,000 on hand to pay off the debt, then you could easily go right ahead and do just that. It would cost you $30,000. No more, no less. If you decided to wait ten years to pay off the debt, then it would have accumulated interest and your total debt would be around $42,318. This number alone would indicate that your debt has increased; however, when the inflation rate of 4% is accounted for you find that the real value of the $30,000 debt has decreased to $28,588 in today’s dollars. By choosing to not pay off your debt, you have actually gained $1,412 in net worth. Of course, the effect becomes increasingly larger with longer time periods. If you waited 45 years before paying off your debt, the total nominal debt would be around $141,071, but the real value of the debt in today’s dollars would be around $24,151. The key point here is to understand that when inflation is outpacing your interest rate, your dollar loses more value than the debt plus interest gains in value. This net negative effect allows you to pay off your debt with weaker dollars in the future.
That example alone is reason enough to not pay off your debt when inflation is higher than your interest rate. It becomes somewhat trickier when your interest rate is higher than inflation, and this is the case most often. Here we will consider opportunity cost and how it affects one’s financial decisions to pay off debt. Let’s say you have a student loan debt of $50,000 at an interest rate of 6.8% while the inflation rate is 3.5%. You are earning $1,000 a month extra that you could use to make loan payments each month. If you paid $1,000 a month, it would take around 59 months or $59,000 to pay off the entire student loan amount. This would be somewhere near $55,000 in today’s dollars. Let’s consider instead the scenario in which you neglect to pay off your debt over the long term, and you instead successfully invest the monthly $1,000 for 59 months and then let it grow for 40 years at an average return of 10% without ever adding another dime. Over 40 years time, the debt plus interest would have ballooned to a whopping $694,736 in nominal terms or about $175,471 in today’s dollars. However, your monthly investments adding up to $59,000 would have grown to a massive $2,670,296 or around $674,443 in today’s dollars. You would have netted around $498,972 extra in today’s dollars just to pay off your debt 40 years later rather than paying it off in 59 months with $1,000 monthly payments.
These approaches require a long term commitment, and they assume constant inflation rates and constant rates of return. Clearly, some people would rather just pay off their debt and not deal with the headache of carrying debt around for 40+ years. There is no right or wrong answer and most people would be more than thrilled to go ahead and pay off their debt as quick as possible. However, it is small decisions such as these that we make throughout our lives that can make us wealthy beyond our expectations. A series of decisions like theses can potentially lead to several millions of extra dollars in your bank account by the time you retire just for making sound and savvy financial decisions that only required a little bit of discipline. Not to mention at retirement the extra dollars would be throwing off passive income of their own making you richer every minute…rewarding you for the simple yet smart decisions made many years ago. Getting rich isn’t hard; it just takes knowledge and discipline to make good financial decisions when the opportunities present themselves.