People generally know how inflation hurts their wallets: The price of everything goes up, and their saved money buys less. But many aren’t aware that inflation can be advantageous in some situations, particularly for those owing money. The actual burden of debt shrinks when inflation is high. Imagine it like this: While wages don’t always rise as fast as inflation when prices are climbing quickly, they usually do increase some during these times. This can make it easier to manage the payments on a fixed-rate loan, like a mortgage or student loan. The key idea is that you’re earning more, but the amount you owe on your old debt stays the same.
According to a research paper by financial experts at Goethe University Frankfurt and the University of Chicago Booth School of Business, only a small number of consumers understand that inflation can benefit borrowers in this way. And the paper also found that, for better or worse, when people learn about this effect, they react by spending more freely and being more willing to borrow.
Inflation and debt: what the research found
The researchers collaborated with an unnamed German financial institution to conduct a research project involving 3,000 of its clients. The study kicked off in July 2022, a time when Germany’s inflation rate hit a record high of 8.7% in the past seventy years.
At the outset of the study, only around one-third of the participants grasped the concept of inflation lowering the true burden of fixed-rate debt. In comparison, a significantly higher proportion, 75% of the participants, understood the negative impact of inflation on the value of their savings held in fixed-rate accounts.
The participants were divided into different groups, with one group receiving information about how inflation eats away at the true value of debt.
Once consumers were informed about debt erosion, they subsequently increased their spending and exhibited a “decrease in fear of debt” when presented with a hypothetical real estate loan scenario.
Why it matters
Consumers develop a rosier outlook on their debt situation and their financial well-being after learning about the impact of high inflation on debt, according to the research paper. These more positive perceptions tend to translate into increased spending.
“Households generally dislike high inflation,” the researchers noted. “However, some households might unexpectedly benefit from inflation: it eats away at the true value of debt with fixed interest rates, essentially shifting wealth from those who save a fixed amount to those with debt.”
It’s important to remember, however, that inflation can also lead consumers to take on more debt as rising prices for everyday items put a strain on their budgets. Additionally, the burden of debt can grow quicker since interest rates on credit cards and new loans typically rise alongside inflation.