Inflation and credit: how does high inflation affect your credit?

High energy and fuel costs, rising food prices: in the spring of 2022, everything will once again be significantly more expensive than it already has been in recent months. The inflation rate turns out to be higher than it has been in about 30 years. Consumers must therefore spend significantly more for the standard of living they are accustomed to. But what does inflation mean for your credit and you as a borrower? Here is positive news for once.

Effects of high inflation on credit: wooden scales - on the right side money coins, on the left side fingers keep the scales in balance

What is inflation and how is it calculated?

Germany's federal statistical office has compiled a basket of goods over time. This includes about 650 products and services that average citizens regularly consume according to statistical samples. For all goods and services in the basket there are real prices. These are summarized in a consumer price index. Changes such as price increases over the previous month or year then result in the national inflation rate or inflation rate.

With inflation, your money loses value. It comes to the loss of purchasing power. That is, with a certain amount of money you can buy less goods than before. The loss of purchasing power does not coincide with the inflation rate.

Example: inflation rate and loss of purchasing power

In the new millennium, inflation often hovered around one percent, and in some phases once reached two or slightly more percent. With two percent inflation, you now have to pay 102 euros for goods that you got for 100 euros a year ago. Or the other way round: for 100 euro you will only get goods and services worth 98.04 euro with a two percent inflation rate. The loss of purchasing power in this case is -1.96 percent.

With price increases around the five percent as in january and february 2022, you had to pay 105 euros for goods that cost you 100 euros in the previous year now. Your 100 euros were then only worth 95.24 euros – a loss of purchasing power of -4.76 percent.

If the inflation rate is high, you will first experience a noticeable loss of purchasing power. Wage increases, pension adjustments or even interest rate increases and more should compensate for this loss. But they always occur with a time lag, if at all, and often do not fully compensate for each other. The picture is somewhat different for consumer loans or a real estate loan.

Inflation and credit – what borrowers need to know

At first glance, you make a good deal with a loan if the price increase is high. So inflation has a positive impact on loans.

Example: inflation and consumer credit

  • You have a year or two ago 10.000 euros as a consumer loan with an effective interest rate of 2.99 percent p. A. Recorded.
  • According to this, the price increases moved towards five percent.
  • In your loan installment, you are now paying principal and interest at a nominal rate of just under three percent. Your bank, on the other hand, will only receive a real interest rate of about minus two percent because of inflation.
  • At the same time, the value of the loan is constantly decreasing. You continue to pay the full 10.000 euros plus interest back. However, these 10.000 euros with a five-year term, fixed interest rate and five percent inflation rate only ends up with an inflation-adjusted value of around 7835 euros.

This is what inflation means for your credit

While goods and services become more expensive during inflation, your credit remains the same. You still pay the same loan installments from interest and repayment, provided that you have agreed on a fixed interest rate.

However, you will have to pay more everywhere, and it will take some time before you are compensated for inflation, for example, in the form of a salary increase. Only then does the relative share of the loan installment in your monthly income decrease. You then have a little more money available for the remaining expenses, but this is quickly eaten up by other price increases.

If you look at inflation from the perspective of an investor, the picture is different. If you had invested the same amount at identical interest rates for five years, your investment would now be worth significantly less than 8000 euros – a high losing deal.

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Special case of home financing: this is how inflation affects your real estate loan.

When it comes to the connection between inflation and credit, another component comes into play: what did you take out the loan for? If you have acquired a tangible asset such as a vehicle or real estate for it, they can benefit especially. Because these material goods show themselves in times of high price increase rates predominantly stable in value.

If you financed a new car with your loan, the loss in value of the vehicle is now lower than when inflation was low. Values of real estate now even increase regularly and thus you as a borrower of a construction loan profit more clearly.

A real estate loan usually has a long-term fixed interest rate. Mostly you could conclude such loans in the last years to very low interest rates. This is where inflation on loans works most effectively for you as a borrower. With a fixed rate for the financing and after inflation has been compensated, you will have more money left over in the month in the longer term. The burden of the loan decreases.

But there is another positive effect of inflation on loans: in times of economic and other crises with high inflation, real estate is in greater demand than ever before. This means that the value of the property usually increases. If you use the property yourself, this increase in value is only theoretical for the time being.

Example: inflation and real estate loans

  • You have a house for 200.000 euros; of this, you contribute 40.000 euros of equity capital. You take out a real estate loan of 160.000 euros at an effective interest rate of 1.5 percent with a repayment rate of three percent on.
  • You pay the monthly loan installment of 600 euros over 27 years; the final installment is 344.53 euros. Loan payments (194.744.53 euros) and equity (40.000 euros) add up to 234 in the end.744 euros that you paid for your house.
  • With an annual inflation rate of two percent, your house has increased in value. In the 27 years of the loan term, the value has increased to a remarkable 341.377,30 euro increased – over 100.000 euros more than you paid for it through your loan and equity.

Capital investors who rent out their properties can pass on the increases in value in the event of high inflation rates directly to their tenants by means of the so-called index rent. Index rents are not subject to rent control and guarantee continuously growing rental income, which is equal to the inflation rate – and at the same time the value of the property increases.