How Does Inflation Affect Financing?

Most will take up some form of financing when they want to purchase a large asset like a vehicle or home. They may also take loans to finance their education, for business or even for personal expenses. When you take a loan, it is vital to ensure that you can repay the stipulated instalment amounts. The loans that banks and most other lenders give are repaid monthly.

However, the amount to be repaid is not just what was borrowed, but also the interest rate being charged. Interest rates are the cost of borrowing and what the lender makes as their return for lending money to you. Inflation can affect your financing by influencing interest rates. The higher the inflation rate, the higher the interest rate on your financing is likely to be. Having to pay more for your financing can make it difficult to repay your debt and increase the likelihood of default.

So how does inflation affect interest rates? Let us first define what inflation and interest rates are.

What is inflation?

Simply put, inflation is the rate at which consumer prices of certain goods and services rise over a given period. In the UK, we rely on the Office for National Statistics (ONS) to provide us with the annual inflation rate that tells us how much consumer prices have increased from the previous year. They arrive at the figure based on how prices have changed on the Consumer Price Index (CPI).

If the ONS announces that the inflation rate rose by 2%, then it means that you are paying 2% more for certain goods and services as compared to the previous year. However, this may not be an exact figure for all goods and services. Some commodities or services may have increased by somewhat more or less than what is announced.

Inflation can be affected by various factors. The most common are:

  • Increase in demand – this refers to demand-pull inflation that is created when there is increased consumer demand for a product or service. When there is a surge in demand, it results in price increases if the effect is short-term, there is not much to be concerned about as the situation will eventually normalise, however, if it is sustained and becomes long-term, it can begin to affect the cost of other goods, spreading the effect across the economy.
  • Increased production cost – this is referred to as cost-push inflation. It occurs when there is an increase in the cost of production for commodities. This increase could come from any cost component such as wages, raw materials or fuel. Though the demand may not fluctuate, this increased cost of the product may force suppliers to reduce their supply of goods to the market. They may also need to increase the pricing of their products, passing on the added expense to consumers.
  • Policy changes – policy changes by the government can impact inflation in different ways. Tax cuts to taxpayers would leave them with more disposable income they can spend. This could in turn raise demand for some products and services, encouraging an increase in prices. They could also offer tax cuts or other incentives to businesses that allow them to better afford capital investments and other spending that would lower their cost of production and encourage a drop in their pricing.

Now that you have a better understanding of inflation, how does it affect lending and borrowing?

How inflation affects lending and borrowing?

Inflation affects lending and borrowing by influencing interest rates. The interest rates that consumers encounter are typically of two types. There is an interest rate you can earn on money that you have saved with the bank. It is a return that the bank gives its account holders for having saved money with them. the more money that you save with them and the longer it remains in the account, the more interest you earn.

The other type of interest is what is applied to loans. When you borrow money from the bank, it is a service they are providing you. In return for the financing, you are required to repay the loan with interest. Interest is the amount over and above what you borrowed which is the bank’s earnings from the transaction. You repay it in instalments spread out over the agreed-upon repayment period, alongside the principal amount you borrowed.

Various factors go into determining the interest rate that a bank will charge you for borrowing their money. It will be pegged on such factors as:

  • Type of loan
  • Loan amount
  • Loan term
  • Interest rate type
  • Credit score

Depending on the bank’s assessment of these and other possible factors, you may find that the rate you are offered is different from that offered to other people.

Another factor that will impact your interest rate is the Bank of England base rate. It is announced eight times a year and is partly pegged to inflation. Thus, if inflation rises, it is possible for the base rate to be increased and thus also increase what interest rate your bank will offer you for borrowing money.

Similarly, if the base rate is reduced, you could end up being offered a lower interest rate on your loan. With an increase to the base rate you can expect to pay more for financing, while with a decrease to the base rate, your bank may decide to lower their interest rate on loans. Keep in mind that because there are many factors at play, these changes may not necessarily result in an impact on your cost of borrowing.

Some banks will take their time in reacting to announcements related to the base rate. They may opt to wait and see, allowing their borrowers to maintain their current interest rates on borrowing for a while longer. Even the amount by which changes are made to the interest rate on loans may differ from lender to lender. Hence the reason a borrower should shop around when taking a loan or other credit, ensuring they are getting the best deal possible.

How does inflation affect financing?

Inflation affects financing by influencing the base rate, which can have an impact on the interest rates that lenders charge borrowers for financing. When inflation surges, the Bank of England may opt to increase the base rate to help reduce it to a more manageable level. The UK’s inflation target is 2%. If inflation rises above this, especially for a long period, raising the base rate may help to increase the cost of borrowing and reduce the spending money that consumers have. With less spending money there is likely to be a decline in the demand for goods and services that will help lower inflation.

There is an inverse relationship between inflation and interest rates as when one goes up, the other is likely to go down. The same applies to financing. When inflation rises, the base rate also increases, leading to higher interest rates. When borrowers are offered higher interest rates, it reduces the loan principal amount they can borrow as more of the instalment they can afford will go towards covering the interest portion that has increased.

This makes taking a loan more expensive when inflation is high. Borrowers are likely to be offered higher interest rates on their loans.

Fixed vs variable rates

The cost of your borrowing will also be impacted by whether you get a fixed-rate or variable-rate loan. If your loan has a fixed rate, the Annual Percentage Rate (APR) and repayments will have already been calculated at the start and will remain the same for the fixed period set. This can be good news if interest rates end up rising as you will avoid having to pay more on your financing.

However, if interest rates drop, you will be forced to carry on with the rate agreed upon, meaning you lose out on a potential reduction in your repayment. Those with a variable rate on their loans will see the interest rate on their financing likely fluctuate based on changes to the base rate. Also, note that you may not have a say in what kind of interest rate will be attached to your loan. Some lenders may have already decided that certain types of loans they offer will only utilise a variable rate.

Depending on what you prefer and when in search of the best deal that will allow you to spend the least amount on the interest repayment, take your time to research your financing options from different lenders. Try to improve your credit score to ensure you are a good credit risk that lenders will want to lend to.