How does inflation affect interest rates?

Inflation and interest rates are two important economic concepts that are constantly in the news. But what do they mean exactly? How does inflation affect interest rates?

In this article, we will take a closer look at these two concepts and how they interact. By understanding inflation and interest rates, you’ll be better equipped to make informed financial decisions. so let’s go !

What is inflation?

Before we delve into the burning question “How does inflation affect interest rates?” First, let’s take a look at what exactly inflation is. Inflation is the general increase in the price of goods and services over time. This is why an item that used to cost €1 in 1920 will now cost €16 in 2022. This is also why that same item could cost you €58 in 2072.

Inflation is known as the “silent killer” of retirement because it creeps up over time, slowly eroding the value of your money. And all sorts of factors affect it – changes in monetary policy, rising production costs or an increase in demand for goods and services.

In France, 1.6% is a “normal” inflation rate. This is what the Central Bank seeks to achieve every year. But this is not always the case.

What is the interest rate?

The interest rate is the rate you pay for borrowing money (or the return you get for saving money). It is expressed as a percentage of the amount borrowed or saved.

For example, suppose you have Balance to be paid €1,000 at an annual percentage rate (APR) of 20%. If you only make the minimum monthly payment, it will take nearly five years to pay off your debt, and you will end up paying over $560 in interest on the money you borrowed.

when you Saving MoneyA higher interest rate is always better because it means the bank pays you more money. But when you’re borrowing money—for a house, a new car, or a business, for example—you want interest rates to be as low as possible, because that saves you the most money down the road over time.

When borrowing, you should also note whether your loan has a fixed or variable interest rate. With a fixed rate loan, your interest rate is locked. So you don’t have to worry about paying more if inflation goes up. (Auto loans, mortgages, and student loans usually have fixed interest rates.)

On the other hand, if you have a variable interest rate loan, it can change at any time depending on the general market rates. So if you have a credit card or something similar whose rate changes from month to month, it’s a variable interest rate.

How do interest rates affect inflation?

How do interest rates affect inflation? When inflation rises, interest rates generally rise as well.

This is because the government wants to encourage people to save money rather than spend it. Lenders want to be compensated for the higher risk they take in lending their money when prices go up.

So if you have a variable interest rate, your rates may increase as well. And if you’re looking for a fixed-rate loan, you may notice higher average rates when you compare options. (You’ll see prices get cheaper if inflation goes down.)

However, other factors (besides inflation) also influence interest rates, such as the economy and political conditions.

How does a central bank use interest rates to control inflation?

Central Bank (BC). It determines, among other things, interest rates for borrowing and savings.

When the central bank wants to increase the availability of money (i.e. stimulate economic growth), it lowers interest rates. Then it becomes cheaper to borrow money, which encourages individuals and companies to spend more.

Conversely, when BC wants to reduce the availability of money (i.e. slow down the economy), it raises interest rates. This makes borrowing more expensive, which discourages people and companies from spending more.

The relationship between inflation and interest rates

Inflation is one of the factors that a central bank takes into account when setting interest rates.

When inflation is high, BC usually raises interest rates to discourage people and businesses from borrowing and spending too much money. This can help keep inflation under control.

Conversely, when inflation is low, BC may lower interest rates to encourage borrowing and spending. This can help stimulate the economy by increasing demand for goods and services (this is exactly what happened at the beginning of the pandemic).

How does inflation affect interest rates as a borrower?

When inflation rises, interest rates on mortgages, credit cards, and loans generally follow suit. And as a borrower, this is bad because it means that loans are much more expensive.

As a result, you may end up paying higher interest on your debt or have a more difficult time being given the car or new home you want.

Below is a real-world example of how inflation affects interest rates as a borrower

The interest rate you pay on your mortgage is one of the most important factors in determining the amount of your monthly payments. And since most people borrow a large amount of money to buy a home, even a small change in the interest rate can have a huge impact on your monthly payments.

For example, suppose you plan to purchase a $350,000 home. You can get some quotes from lenders and find that interest rates are currently around 4%. it is good.

Now let’s fast forward to the next six months. You’re finally ready to get a mortgage, but rates are down to 4.5%. It’s only 0.5% more than before. So this is not a problem, right?

The problem is that over the life of the loan, you end up paying €36,000 extra in interest with the 4.5% loan. That’s a huge difference…even if it’s only 0.5% higher.

How does inflation affect interest rates as a provider?

Well, what is the effect of inflation on interest rates when saving money?

We’ll tell you this: When it comes to saving and investing, high rates of inflation erode the value of money over time for savers and retirees. (Remember how we called it the “silent killer” earlier?) Here’s why…

Let’s say you have €50,000 in a savings account with 0.5% interest. If inflation is 3%, the real value of your money (i.e. its purchasing power) decreases by 2.5% each year. In other words, even with interest, your money goes down and you can buy fewer items over time.

On the bright side, rising inflation means that interest rates on savings accounts can rise, too. But still, these interest rates are hardly enough to beat inflation, even under the best of circumstances.

How do we protect against the impact of inflation on interest rates?

There are several things you can do to protect yourself from the impact of inflation on interest rates:

1. Compare to get the best mortgage rate when buying a home

If you’re a homeowner (or soon will be), one of the best ways to protect yourself from inflation-related interest increases is to compare rates from different lenders. (Some experts recommend getting quotes from at least five organizations.) And if you already have a mortgage but rates have dropped dramatically, consider refinancing it.

Consider going for a fixed rate mortgage so you don’t have to worry about your monthly payment increasing with inflation. This is one of the biggest problems with variable rate mortgages and balloon mortgages: Your rates can jump at any time, even if interest rates go up.

2. Invest for your future

Investing is one of the only ways to generate an average return above inflation, which is essential if you want to build real and lasting wealth for your future.

Yes, you want to keep an extension emergency fund And other short-term funds in an easy-to-access savings account. But if you want to have a chance to beat inflation, you have to invest.

These investments can be mutual funds, ETFs, inflation protected securities, etc. The idea is to pose Diversified portfolio whose average return is higher than the average rate of inflation.

3. Breathe deeply and stay calm

It’s almost impossible to turn on the TV and not hear a news anchor talk about inflation rising to new levels. The news is designed to make you anxious.

One of the best ways out is to turn off the TV, take a deep breath, and remember that inflation is normal. Even when it’s high, it always resolves.

Conclusion: How does inflation affect interest rates?

As you can see, the effect of inflation on interest rates affects your finances personally. However, inflation is a fact of life, and it can have a significant impact on interest rates.

But by understanding how inflation works and taking a few simple steps to protect yourself, you can reduce the negative impact it has on your finances.