How to Consider Inflation & Interest Rates to Make Great Financial Decisions

Duh, Melissa, you say. Making good financial decisions is easy. If you have two options, and one has a better value, then pick the option that’s a better value.

Oh my goodness! My billion dollar idea! Why has no one ever thought of this before?!!! 🤣

Making a “good financial decision” can be incredibly complicated. Many factors go into making any decision, and trying to see the future to make the “best” financial decision can be overwhelming. Complicate that by considering that your short-term desires may not match your long-term goals… yes, it’s very hard to consistently make great financial decisions! 😬

One way to do that is to use the Good, Better, Best method for decision-making. In today’s article, we’re going to learn the basics of inflation, and how to compare interest rates and inflation to make great long-term financial decisions.

Inflation & Buying Power

Inflation is the economic measure by which prices naturally rise over time.

This is generally a good thing for the economy- when prices rise, so do wages and home values, and that benefits you directly.

Raising prices of goods and services can be indirectly good for you, too; when prices rise, companies can make more profits. When companies are more profitable, they can expand their business operations- making improvements to business offerings, and ultimately hiring more workers. (Please note that “trickle-down economics” has never been proven to work on a large national scale 😆 but inflationary principles are more obvious in small businesses and smaller communities)

Big deal, Melissa. Eggs cost less $0.50 a dozen back in 1920; a dozen eggs costs four times as much today… but wages have gone up over time, too. That’s how inflation works, and it’s pretty normal & easy to understand, right? 🤨

True! All true. But knowing how inflation works means that you’ll know how to make it work for you.

What do I mean by that? Well, when you are evaluating how you want to use your money- what’s a “good deal”, deciding whether an opportunity is a good investment- then knowing how inflation works can help you make better financial decisions.

In other words, understanding inflation means that you understand the buying power of each dollar you control 💰

Buying power is the principle that considers the actual value of each of your dollars. When inflation goes up, each dollar has less actual power. This isn’t that scary an idea, when you consider that you will earn higher and higher amounts of dollars over time; but it is something to keep in mind in making financial decisions.

Currently, inflation in the middle of 2020 is low. Keeping inflation low can keep an uncertain economy stable- low inflation flattens out volatility in retail sales, the stock market, etc. An “ideal” inflation rate- one that keeps the economy stable, and encourages growth- is anywhere between 0% and 2%; current inflation is under 1% 🙂

Considering Inflation and Interest Rates in Financial Decisions

While inflation raises wages over time, by and large this does not happen for each individual in their current job. Most companies do not offer regular raises anymore; it was common decades ago, when workers stayed at one company for many years. But over time, economic and social changes made it less common; now, workers find new jobs or move to a new company when they need a raise. There are exceptions to this- some companies and government employers offer “cost of living” wage increases- but usually, your income will rise only when you find a new job 👨‍🍳 👨‍🔧 👩‍💼 👨‍🔬 👨‍🚒 👷

It’s always nice to have more income, but remember to use inflation to measure the actual improvement in your earning power. Let’s say you’re looking for a new job, and you are luckily a job that will guarantee you a “cost of living raise” of 1.5% per year, that may seem like a great deal! But remember that inflation can vary from year to year; current inflation is only 1%, but that number fluctuates and usually hovers around 2%.

So let’s say your job gives you a 1.5% raise per year, but inflation averages 1.9% per year for the next ten years. That means that if you stay in that job for 10 years, your earning power will be less in 10 years than it is today! 😳

Another example of considering inflation is looking for a new bank account. Let’s say your bank has done you wrong, and you’re looking for a new bank. One bank offers you a no-fee checking account, which is attractive; another bank is offering “great interest rates” on their savings accounts. You’re a smart, savvy shopper, so you check online for “best savings account interest rates”, and you find that indeed, the average rate on a savings account is current 0.3%, and your potential bank is offering 0.4%. Wow! That’s 33% higher than average!

Slow your roll there, friend. Before you run over to bank #2 to throw your money at them, let’s consider the effects of inflation. If you will be earning 0.4% interest per year on the money in your savings account… but inflation is increasing the price of goods by 1% per year… then your money will lose earning power if you park it in that savings account! Best to go with the first bank and its fee-free checking account 👍

Considering Inflation and Interest in Investments, Debt Payoff, Etc

You can use this sort of savvy thinking when you make investment choices, too. Inflation doesn’t affect a lot of these decisions, because inflation will generally affect all these options equally. But here is where interest rates matter more than inflation alone; some choices are really obvious. If you have the choice of two investments that are exactly the same, except one offers a better potential interest than the other, that math is easy- go with the one that will earn you more interest. Conversely, if you are refinancing your mortgage, then you select the option with a lower interest rate.

(Note that all other loan terms must be identical, for the lower interest rate to always be the best option. In mortgages, loans with slightly higher interest rate can have other attractive advantages. More on that in another Smart Money Minute!)

When you pay off debt, do you always pay off the debt with the lowest interest rate? Yes!

If, that is, “no debt” is your highest financial priority 🤔

What if your highest financial priority is to increase your wealth? Then let’s look at a different option.

Let’s say you have an auto loan that’s at 3% interest, and you will pay off that loan in 5 more years. You got a raise-good job, you!- and now you’ll be bringing home an extra $400 per month. Boy, you think, I could pay off my auto loan in less than 3 years, if I put that money into my car payment 🤑

That would be awesome! 😎 But then you remembered this amazing article from a while ago, Smart Money Minute you think- Yes! Now That’s Smart Money 🧐

A-ha! You think. I know what to do with that $400! 😊

You know that if you put that money into your auto loan, you can save a few hundred dollars in interest and pay off your auto loan faster. But that loan is costing you 3% per year.

If you take that extra money, and put it into an investment account that earns 5% in a year, then you are earning more in interest than you are spending.

It will still take you five years to pay off your auto loan. But at the end of 5 years, you will have more money than if you paid off your auto loan early, and then invested the money 💸

You still might choose to go that route. If being debt-free is more important to you than building your wealth, then that is a higher priority. Always follow your own priorities! 😁

But if you are more interested in overall better financial outcomes, then evaluate each financial opportunity, before just throwing money at the highest interest investment, or the lowest interest debt 👍

Now That’s Smart Money 🧐