If you have a large outstanding debt with a fixed interest rate, such as student debt or mortgage, your debt may be significantly reduced by inflation if the real inflation rate is way higher than your fixed debt interest rate.
Yes, you have heard it. Your debt or student debt will be reduced by this high inflation if it continues over the years. And that is good news.
So, there is a silver lining in all this bad economic environment after.
I will not divulge into economic formulas here for the sake of your understanding and the economy of my time.
I will try to explain in simple terms how this works.
For example, you owe $100,000 worth of student debt or mortgage with a 10% interest rate.
That means that in one year you will own $110,000. And in 10 years with interest your debt will amount to roughly $110,000 + $98,550 = $208,550.
I mean, that’s a whole house gone in the wind with interest accrual. See, why the banking industry is so rich and powerful?
Now, let’s say that real inflation is all the way crazy at 20%. Which is about what we have right now. How that will affect your student debt or fixed rate in real terms?
This is a very rough calculating just for the sake of an example. Inflation at 20% means that every year value of the dollar will plunge by 20%. That also means that the value of your outstanding loan in real (current) money also plunges/reduces by 20%.
And with a 10% interest rate, it means that an Inflation rate of 20% minus 10% interest rate – your whole interest rate growth gets canceled out by inflation. Moreover, an extra 10% of inflation remaining now additionally reduces your debt principal of 100,000 by 10% each year.
Technically, with such inflation, your debt gets reduced by 10% each year rather than growing by 10%. AUTOMATICALLY!
And after the first 2-3 years such a reduction accelerates because of the interest rate.
Roughly speaking, your 100K loan outstanding debt will become 88K just after one year even with 10% interest. Then becomes 77.5K after the second year of such inflation. Then 68K after the third year of such inflation. Then roughly 60K after 4th year, and 53K after 5th year. Even without any payments on your part!
Even if inflation stops now and things return to normal – you will have interest payment roughly ½ of what it was originally. Easier to manage, right?
And for the sake of example, if such inflation continues over 10 years (we are dreaming here), then your 100K loan balance will automatically become….just $18,000! That’s 5 times less than the original principal without any payments on your part!
Now you can really pay off your loan without too much pain.
Please note, that the above calculations are very rough just for the sake of example. Real-life numbers will be different but overall this is how inflation can reduce the outstanding student loan or mortgage debt.
Too bad, I did not take out a mortgage for a large building couple of years ago, right? But I would not be able to manage it anyway.
Proof?
If you do not trust me – I have made some research about this. Many economists and financial writers support my conclusions.
Inflation makes it easier to pay debt away. True, there are many bad sides of inflation like wiping out savings in currency.
But, as far as I know, many people especially those with large student debts, do not have much savings. Thus, inflation is helping, rather than hurting them. Prices will go up but so should salaries.
The most famous example is France during WWII. It was in loads of debt. But the inflation hit 50% and quickly pretty much wiped out debts in France.
People with assets will see the value of assets continue to go up with inflation albeit a little bit lagging. I would not keep my savings in currency though because currency loses value in inflation.
Keeping money in hard assets may be better but please consult with your financial advisor because nobody knows for sure how inflationary pressures will play out.
There are many hard assets from real estate to gold or platinum, which often hold value well in hard inflationary times. But I cannot advise anyone on how to invest – do your own research.
Said that I doubt government and federal reserve plus central banks will allow high inflation to run for 10 years. I give at a maximum of 5-6 years. Otherwise, there may be a collapse of currencies.
But inflation in higher single digits may be here for the long run, essentially keeping your student loan from growing after a reduction in amount by several years of high inflation.
Anyway, while this is a reason to celebrate a little, do not sit back and relax. Debt is still there, and you may have to deal with it. Get skills, get a job, get ready to start a business – anything that gets you a nice income.
And be prepared that in the future your debt will become smaller and you can repay it more easily than now.
And note that your wages are almost always playing a catch up game with inflation. Meaning, that inflation hits hard in the short term, but wages rise in the longer term to match inflation.
Also note, borrowing money DURING high inflation is usually a bad idea because interest rates are too high. Eventually, inflation will slow down, and you do not want to be stuck with a high interest rate. I would say, 7% for a student loan is a rip-off in any case. If you can get lower – get lower.
And try to avoid debt altogether. Try to go to a cheaper college, state tuition, or scholarship, or avoid going to college altogether.
Getting a trade profession that pays real bucks and being debt-free is much better than post-graduate unemployment with debt ballooning and snowballing as you lose sleep every night because of it.