How Inflation Impacts Your Debt

How Inflation Impacts Your Debt

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There’s no doubt that high inflation can put a strain on your budget as it makes day-to-day spending more expensive. But what impact does inflation have on the debt you owe, be it a mortgage, student loan, or credit card? If prices rise during inflationary periods, does the value of your debt increase as well? Will you end up paying more each month to service your debt?

In Canada, the annual inflation rate in May was 7.7%, the highest in nearly 40 years. As a result, the cost of goods and services has spiked, especially for housing, food, and energy, causing severe financial stress for countless households.

Given that the average Canadian household owes $1.80 for every $1 they earn, understanding how inflation affects debt is essential. In doing so, you can better navigate this challenging environment and keep your financial house in order.

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How inflation affects your debt – the good and the bad

Inflation can have a favorable or unfavorable impact on your debt. It depends on various factors, including:

  • The amount of debt you carry
  • The type of debt you carry (line of credit, personal loan, etc.)
  • Whether you have primarily long-term or short-term debt
  • Whether your long-term debt is up for renewal or locked in for an extended period

The positive effects of inflation on debt

If you’re primarily a borrower rather than a saver, you may benefit financially from high inflation. The reason is that during an inflationary environment, you pay back your lenders with money worth considerably less than when you originally borrowed it.

For example, assume you currently have $10,000 outstanding on a personal loan. You received this loan when the inflation rate was 1% and negotiated a fixed interest rate of 4% with your lender. 

If inflation spikes to 6%, you continue paying 4%, despite lenders issuing similar new loans at much higher rates. The value of your debt now has decreased to $9,400 ($10,000 x (100% – 6%)).

You benefit even more if you have a fixed-rate mortgage. Suppose you locked in a low interest rate for a five-year term. In that case, your payments will remain the same while your home’s price rises, boosting your home equity.

Let’s say your employer also raises your salary to help you counteract the escalating prices. In that case, you’ll have more funds available to cover your daily expenses and still have enough left to meet your mortgage payment obligations.

The negative effects of inflation on debt

The primary reason inflation is bad for debt is that it triggers a rise in interest rates.

As inflationary pressure persists, The Bank of Canada eventually steps in to cool down the economy by raising its lending rate. In turn, this action increases the borrowing cost for financial institutions who react by hiking the rates they charge on loans they issue.

A steep increase in interest rates results in larger payments, especially on certain types of mortgages. [m1] You may struggle to handle the higher debt load depending on how much space you have in your budget.

Do your debt obligations consist mainly of variable-rate loans, such as an adjustable-rate mortgage and line of credit? If so, you can expect an increase in your payments following a BoC rate hike. The reason is that rates on these loan products fluctuate periodically based on your lender’s prime rate, which moves in tandem with rate changes imposed by the BoC.

As mentioned, if your debt primarily consists of fixed-rate loans with lengthy terms, you’re shielded from rate hikes. However, the scenario changes once it comes time to renew your loan. Now, you’ll have no choice but to lock in a new term at an excessive rate.

There’s another reason inflation worsens a household’s debt problems. With prices for almost every good and service rising, there’s less money left to cover debt payments.

As an ever-greater portion of your budget consumes essentials like food, energy, and rent, tackling debt becomes increasingly difficult. While a cost-of-living raise can help offset the additional expenses, many people are not fortunate enough to receive one.

If prices for basic living expenses exceed your income, you’ll have little choice but to borrow more money to make up the difference. As a result, you’ll take more time to repay your debt.

With a heavier debt burden, you may begin to make payments less frequently. If you have a large balance on a credit card or line of credit, you may resort to paying only the minimum required each month. Unfortunately, this will result in more interest charges on your account, putting you further into debt.

In addition, late payments coupled with higher debt load will impair your credit score. And should you begin missing payments altogether, you risk defaulting on your debt.

Eventually, your creditors will grow anxious and initiate debt enforcement actions, such as seizing your assets or sending your past-due accounts to collection agencies.[m2] 

Not surprisingly, a study by the Brookings Institute found that inflation adversely affects poor and middle-class households more than their upper-class counterparts.

How to manage your debt during periods of high inflation

High inflation can cause severe and prolonged financial hardship for many households, especially those in the lower-income brackets. Today, we’re experiencing levels of inflation not seen in nearly two generations, so it’s crucial to do everything possible to prepare.

Here are some tips for managing your debt as inflation skyrockets: 

  • Prioritize paying down your high-interest debt first.
  • Cut back on discretionary spending.
  • Make a lump sum payment toward your outstanding balance to accrue fewer interest charges.
  • Consolidate high-interest debt using a personal loan or balance transfer credit card that offers a lower rate.
  • Lower your credit limit on your credit card or line of credit to prevent overspending.
  • Ensure you contribute at least the minimum payment required on your credit card or line of credit to keep your account in good standing.
  • Lock in current rates on long-term loans for as long as possible.
  • Cash in your savings to help pay for daily expenses
  • Move into a more affordable home
  • Find a side hustle to earn extra income
  • File for bankruptcy or a consumer proposal[m3] 

Has soaring inflation left you struggling to keep up with debt payments? A consumer proposal or bankruptcy can provide a solution

There’s also no way to know when inflation will subside, so taking steps right away is vital to get your debt under control. But let’s say you’ve exhausted all the obvious methods – what then?

A consumer proposal or bankruptcy are two viable options to help you eliminate burdensome debt.

Filing a consumer proposal will allow you to arrange new payment terms with your creditors. You can negotiate to have a portion of your debt forgiven, leaving you with a more manageable balance to repay. Also, it’ll stop all interest charges, wage garnishments, and pestering collection calls from creditors.

If your debt situation is critical enough, bankruptcy may be a better alternative. By filing for bankruptcy, you can safely discharge unsecured debt like credit cards and lines of credit. Creditors will be unable to pursue legal action against you, allowing you to start fresh and get your finances in order.

Unsure of how all this works or where to begin? If so, the first step is to contact a Licensed Insolvency Trustee.

A Licensed Insolvency Trustee is the only professional trained and authorized to discharge your debt through a government-regulated program, such as a consumer proposal or bankruptcy. They can sit down with you to assess your predicament and offer a debt relief solution that’s right for you. They’ll help you craft a plan that eliminates or reduces your debt while minimizing the impact on your credit score and personal assets. [m4]  While you can’t control the inflation rate in the economy, you can do plenty to rid yourself of troublesome debt and lay the foundation for a brighter financial future. Book a call with a Licensed Insolvency Trustee today.

Featured Image by Pixabay from Pexels

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