Prices change from year to year, whether it's a house, or college, or a loaf of bread. When prices increase over time, it's called inflation, and the inflation rate is this year-over-year change expressed as a percentage. The U.S. once saw inflation rates as high as 13.5% in 1980 and as low as -0.36% in 2009; in 2019, it was 1.8% and expected to rise only slightly over the following few years.
Increasing prices result in your money not going as far as it once did. Maybe you could buy four candy bars with a dollar in 1980, but today you could only buy half of one; that's inflation. It affects interest rates, bank accounts, loans, and other financial activities. Find out what effect inflation may have on your bank accounts and what, if anything, you can do about it.
Inflation vs. Savings Account Interest
When inflation rises, your purchasing power goes down. If inflation outpaces the interest you earn on your bank account, it will feel like losing money. Your balance might be increasing, but not enough to keep up with higher prices.
For example, say you deposit $1,000 in a savings account with a 0.09% annual percentage yield (APY), which was the national average in 2019; after a year, you'd have earned 90 cents in interest. But if the inflation rate is 1.5%, what you could have bought with $1,000 costs $1,015 a year later. You're effectively behind by $14.10 due to inflation, even though you earned interest.
Although 0.09% is the national average APY, there are still some ways to come close to (or occasionally even beat) inflation; online high-yield savings accounts and some certificates of deposit (CDs) are two places to look.
What Will Happen If Inflation Goes Up?
If inflation heats up in the coming years, you can expect a couple of things to happen: Less purchasing power for the money you’ve saved, and rising interest rates on savings accounts, CDs, and other products.
Loss of Purchasing Power
When you save money for the future, you hope it will be able to buy at least as much as it buys today, but that’s not always the case. During periods of high inflation, it’s reasonable to assume that things will be more expensive next year than they are today—so there’s an incentive to spend your money now instead of saving it.
But you still need to save money and keep cash on hand, even though inflation threatens to erode the value of your savings. You’ll need your monthly spending money in cash, and it’s also a good idea to keep emergency funds in a safe place like a bank or credit union.
Rising Interest Rates
The good news is that interest rates tend to rise during periods of inflation. Your bank might not pay much interest today, but you can expect your APY on savings accounts and CDs to get more attractive if inflation increases.
Savings account and money market account rates should move up fairly quickly as rates rise. Short-term CDs (with terms of six or 12 months, for example) might also adjust. However, long-term CD rates probably won’t budge until it’s clear that inflation has arrived and that rates will remain high for a while.
The question is whether or not those rate increases will be enough to keep pace with inflation. In an ideal world, you’d at least break even; even better if your savings grow more quickly than prices increase. But in reality, rates lag behind inflation, and income tax on the interest you'd earn means you’ll probably lose purchasing power.
Effect of Inflation on Loan Payments
If you’re concerned about inflation, you might get some consolation from knowing that long-term loans could actually get more affordable. If a loan payment of a few hundred dollars feels like a lot of money today, it won’t feel like quite as much in 20 years.
- Long-term loans: Assuming you don’t intend to pay your loans off early, student loans that get paid off over 25 years and 30-year like a fixed-rate mortgage should become easier to handle. Of course, if your income fails to rise with inflation or if your payments increase, you will indeed be worse off. Also, reducing debt is rarely a bad idea because you still pay interest over all those years if you keep the loan in place.
- Variable-rate loans: If the interest rate on your loan changes over time, there’s a chance that your rate will increase during periods of inflation. Variable-rate loans have interest rates that are based on other rates, or benchmarks. A higher rate could result in a higher required monthly payment, so be prepared for a payment shock with these loans if inflation picks up.
- Locking in rates: If you’re planning to borrow soon, but you don’t have firm plans, be aware that interest rates may be higher when you eventually apply for a loan or lock in a rate. If that happens, your payments will be more each month. Leave some wiggle room in your budget if you’re shopping for a high-value item that you’ll buy on credit. To understand how the interest rate affects your monthly payment and interest costs, run some loan calculations with different rates.
Effect of Inflation on Retirement Savings
Another area where inflation can hurt your savings is in your retirement account. After all, if money becomes less valuable over time, a figure that could support your lifestyle comfortably today won't have the same buying power years from now.
Even if you sock away 15% of your income, as many experts suggest, inflation can eat away at the gains you might make in your 401(k) or IRA. If your retirement accounts gain 6% a year in interest (and they're certainly not guaranteed to increase in value), an inflation rate of 2% or 3%—plus taxes and fees—can leave your net return well south of that. Properly balancing your portfolio is a strategy used to combat the effects of inflation on your retirement accounts.
What You Can Do to Beat Inflation
You don't need to resign yourself to losing out to inflation. There are a few things you can do to try to keep ahead of it (or at least not fall behind).
- Keep options open: If you think interest rates will rise soon, it might be best to wait to put cash into long-term CDs. You can use a laddering strategy to avoid locking in at low rates since it’s hard to predict the timing and speed (as well as the direction) of future interest rate changes.
- Shop around: A rising rate environment would be a good time to keep an eye out for better deals. Some banks react with higher interest rates more quickly than others. If your bank is slow, it might be worth opening an account elsewhere. Online banks are always a good option for earning competitive savings rates. But remember that the difference in earnings needs to be significant for you to come out ahead: Switching banks takes time and effort, and your money might not earn any interest while moving between banks. Plus, the bank with the best rate changes constantly—the important thing is that you’re getting a competitive rate. Changing banks will make the most sense with particularly large account balances or significant differences in interest rates between banks. With a small account or minor rate difference, it’s probably not worth your time.
- Long-term savings: Do some planning to make sure you have the right amounts in the right types of accounts. Bank accounts are best for money that you will need or might need in the near-to-medium term, like your emergency fund. If you lose a bit of purchasing power due to inflation, that’s the price you pay for having a liquid source of emergency cash. It's best to talk with a financial planner to find out what, if anything, you should do with longer-term money.