Question: How can inflation reduce value of personal debt?

Readers Question: I understand that inflation can cut the value of debt for countries and companies, because higher prices mean more revenue for the same output therefore additional money to pay of debt. However, does this apply to personal debt? i.e. unless my wages are rising with inflation I have no extra revenue and therefore same (or possibly less) money to pay off my debt. Am I right in thinking this?

You are correct. Your personal real debt burden will fall, if you have an increase in wages / income which makes it easier to pay it back.

Inflation can reduce the value of debt, if your wages keep pace with inflation. It is possible to have inflation with no increase in income. In this case, it is more difficult to pay off your debt. Your income is the same, but you have to spend more on buying goods leaving less disposable income to pay your debt.

Usually in the UK, inflation causes nominal wages to rise. Wages usually rise by more than inflation. e.g. if inflation is 5%, workers may get 7% increase.
Clearly, if you owe a £1,000 but your nominal wage is rising 7% a year then the real value of your debt will be falling.

Interest Rates and Debt

However, another factor to bear in mind, is interest rates. Higher inflation usually means higher interest rates. If you are borrowing from a bank the interest rate is likely to be above the inflation rate. Although the real value of the debt falls with inflation, you are paying more interest on the loan.

Unexpected Inflation

If you have a debt, the best thing is to have a fixed interest rate, then unexpectedly high inflation. This means the real value of the debt unexpectedly falls, but your interest cost remains the same. (On the alternative view, unexpected inflation, is bad news for savers who have a fixed interest)

Example Mortgage Debt and Inflation.

In the post war period, wages have generally risen faster than inflation; there has been an increase in real incomes. Mortgage holders take out a loan for 30 years. When they begin repaying their mortgage, it takes a high % of their income. But with inflation and rising incomes, these mortgage repayments decline as a % of their income. As time progresses, it becomes much easier to repay their mortgage. Thus inflation / rising wages helps to reduce the value of their debt.

Falling Real Wages

In 2010/11 we are experiencing an inflation rate higher than nominal wage growth. This means real wages are falling. Therefore, with low wage growth, the real value of debt is falling only by a small amount and we have rising living costs.

Bank interest rates are currently higher than nominal wage growth. Therefore it is not a good time to be a borrower. Unless you have a tracker mortgage which links mortgage rates to the base rate.


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