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Why (Good!) Debt Is Your Friend In An Inflationary Environment

Why (Good!) Debt Is Your Friend In An Inflationary Environment

A person sitting at the kitchen counter looking at a laptop and bills.

Inflation is a persistent problem that has been raging for several months, even though it was not as “transitory” at first thought by policymakers. Jerome Powell, the Federal Reserve Board Chair, had a noticeable shift in tone earlier this month. Janet Yellen, former Chair and current Secretary to the Treasury, said that it was time to stop referring to inflation as temporary.

InflationThis can have a huge impact on your personal finances. Your budget can feel tighter if your dollar isn’t as strong as it was the previous month.

You can still make a profit if your rate is fixed in a high inflation environment.

A person sitting at the kitchen counter looking at a laptop and bills.

Image source: Getty Images.

Low-rate loans can be a moneymaker

You are likely to have a mortgage rate that is lower than what previous generations would consider impossible if you purchased or refinanced a house within the last 1 1/2 years. It’s not only mortgages. There are many types of loans that have very low interest rates, including student loans, car loans, personal loans, and all other types.

Thank you Fed policies for setting the target. federal funds rateIt was maintained at 0% to 0.25% while stocks recovered to valuations never seen since the dot.com bubble. As a result, bond buyers were reluctant to accept yields at record low levels.

It’s a smart financial move to lock in a long-term fixed rate loan as soon as possible.

The average home loan currently stands at 4%. Inflation in the last year was well over 6%. The effective real interest rate at these rates is negative. In other words, anyone who has a reasonable mortgage has greater buying power today than someone who has had to pay debt in the last year.

I’m not suggesting that you should acquire as much long-term fixed rate debt as possible. However, if you are able to use debt to finance purchases that were already planned, it will be a huge benefit to your finances in an environment of high inflation. If you have low-interest debt such as a student loan, mortgage, or car loan, don’t pay more than your minimum monthly payment.

What to do when you have extra capital

The problem with holding onto excess capital rather than paying down your debt is that you can’t just put it in a savings account. The overnight rate at 0% means that most banks won’t offer much more than that for deposits. Even though the interest rate may be very low, you would get a higher real return by paying off your existing debt.

You will need to invest the extra capital and take some risk. Here are three things to do with extra capital, instead of paying down debt.

You can invest in Series II Savings bonds. Series I savings bonds have an adjustable interest rate that is adjusted every six months based on inflation. The interest rate was 7.12% as of April’s most recent adjustment. Based on the inflation rate at the time, the rate will be adjusted again in April.

Series I bonds protect your cash against inflation. The interest you pay on the bonds is exempted from local and state taxes. However, you will have to pay federal income tax which reduces your effective rate of interest. The downside is that you must keep your money in a locked location for at least one and a three-month penalty for withdrawing before five years. You are also restricted to purchasing $10,000 per person per annum.

See Also

You can also add to your portfolio. Your portfolio should outperform inflation over the long-term. However, given the current market valuations, real returns could be lower than historical averages.

If you don’t have enough funds in retirement accounts, they are a great place for extra money. Contributing to retirement funds can increase your investment returns due to the additional tax benefits. Although there are creative ways around this problem, most capital is tied up until retirement. These funds can be accessed earlyIf you have any questions, please let us know.

Low-interest fixed-rate, low-interest debt is a great financial option right now. This assumes you can afford the monthly payments and have additional money each month to invest. As long as inflation continues its high pace, you shouldn’t be paying any additional debt. Instead, invest the extra cash to gain more purchasing power in the future.

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The views and opinions expressed in this article are those of the author and not necessarily those of Nasdaq, Inc.

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