The impact of inflation on debt repayment: Challenges and strategies

Inflation can be bad news in lots of ways. But what does it mean for your debts?

If you’re focusing on reducing what you owe, there are a few things you should know about inflation and its impact on interest rates, as well as the wider economy.

Understanding inflation and its effects

What is inflation anyway?

When we talk about inflation, we are usually referring to an increase in the price of goods and services over a period of time.

The Stats NZ consumer price index, for example, measures the increase in price of a range of things households spend money on and reports that rise quarterly and annually.

As things generally get more expensive, the purchasing power of money is reduced, making each dollar worth less.

That’s why what you could buy for $10, 50 years ago, seems significantly more compared to what it would buy now. The Reserve Bank has a calculator that demonstrates this effect.

In New Zealand, it’s part of the Reserve Bank’s job to keep inflation in its medium-term target range of 1 percent to 3 percent per annum. It attempts to do that primarily with the official cash rate (OCR).

When inflation starts to look like it’s getting too high, the bank generally increases the OCR to reduce consumer and business spending (by increasing the cost of borrowing). The OCR is the price banks pay when they borrow money from the Reserve Bank.

The impact of inflation on debt repayment costs

It’s that Reserve Bank response that means that repaying debt can be more expensive when inflation is higher.

If you have debt that has a variable or floating interest rate, you may find that when the Reserve Bank increases the OCR to try to bring inflation under control, the rate you are charged by your lender increases.

At the same time, the impact of inflation might be hitting your bank account through rising costs for your daily expenses, which may mean you have less money available to cover your debt repayments. This double-whammy is part of the cost-of-living squeeze that has hit many households in recent years.

In real terms, the value of your debt may drop during periods of high inflation because the value of each dollar you owe has been eroded, particularly if you receive wage rises, too. But that is often not much comfort when the repayments are harder to manage.

Many personal loans have fixed interest rates, which means you don’t have to worry about your rate rising, but you can still find inflation puts pressure on your household budget and may make the payments tougher to cover.

Strategies for managing debt repayment in an inflationary environment

There are some things you can do if you are worried about coping with debt in an inflationary environment.

Pay down your debt

When interest rates are rising, paying off your debt faster can be particularly effective. If you can reduce what you owe, there won’t be as much of a balance to attract higher interest. Just check that you aren’t charged any additional fees to do this.

Consider your loan term

If you’re feeling the crunch and struggling to make your payments, you could opt to extend your loan term. This may reduce your regular payments, although you could pay more overall in total interest.

Refinance or debt consolidation

If you’re finding your loans hard to manage, you could consider refinancing or consolidating them. Debt consolidation means you combine a number of loans into one. This helps reduce the administration involved in making sure you meet all your payments, and if you can get a lower interest rate or a shorter term, it may reduce the loan cost.

Managing interest rates and debt repayment

Your interest rate is an important component of the cost of your loan.

Fixed interest rates offer stability and predictability and can protect you from the impact of rising interest rates if inflation picks up. But if you fix it at a time when interest rates are high, it may mean you pay more than you might otherwise.

Variable rates can be affected by changes to the OCR and can rise, but they can also fall.

When you’re looking at your loan options, it will be important to understand what type of interest rate you have and what that means for the future track of debt.

Real versus nominal interest rate

You might have heard people talk about a “nominal” and “real” interest rate.

The nominal rate is the rate you agreed to pay your lender – for example, 20 percent per annum on a credit card.

The “real” rate takes inflation into account. A 20 percent per annum interest rate when inflation is at 4 percent is 16 percent per annum.

The effects of inflation on consumer behaviour

Inflation can make a big difference to how people are spending money.

Sometimes, if wages are also rising quickly, an inflationary environment can be quite a buoyant one, where people are confident and spending, adding to the inflation.

But if inflation is rising ahead of wages, it puts household budgets under pressure, and discretionary spending generally drops.

Inflation expectations – the measure of what people think will happen – also matter. Broadly, what people expect to happen is more likely to occur. If the general public is expecting price rises, it can become self-fulfilling because people are willing to pay higher prices, and expect that prices will be higher in future.

It’s not just households that are affected by inflation. Businesses also experience an increase in costs and can also be hit by a drop in demand for their services if the increase in interest rates has the intended impact of slowing spending in the economy.

Practical tips for managing debt repayment

If you are under pressure, worried you might be in the future, and concerned about your debt repayments, there are a few things you can do.

• Talk to your lender. A first stop should be to check in with your lender to talk about your options. They will be able to talk to you about whether any of the terms of your loan could be changed and help you with a debt repayment plan.

• You may be able to extend your loan period, which reduces repayments but can add cost overall.

• Look at your options – we may be able to help you find a lender with more appropriate terms and conditions and move your outstanding balance.

• Talk to an adviser, such as the team at better finance™, about your options.

Inflation can be concerning, but it does not need to knock you off your financial path.

If you have any questions about existing loans or lending you might need in future, get in touch with the team at better finance™.