Learn How Inflation Affects Your Bank Account

Shrinking Dollar
Inflation shrinks the purchasing power of a dollar. JOE CICAK/E+/Getty Images

Inflation happens when prices increase over time. If you’ve ever heard people talk about low prices in previous decades, they’re indirectly describing inflation. Still, inflation can be hard to make sense of, especially when it comes to managing your finances. If inflation heats up in the coming years, you might expect several outcomes:

  1. Less purchasing power for the money you’ve saved
  2. Rising interest rates on savings accounts, certificates of deposit (CDs) and other products
  1. Loan payments “feeling” more affordable over the long-term

Loss of Purchasing Power

Inflation makes money less valuable. The result is that one dollar buys less than it used to every year, so goods and services appear more expensive if you just look at the price quoted in dollars. The inflation-adjusted cost might stay the same (or it might not), but the number of dollars it takes to buy an item still changes.

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 obviously 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.

Interest Rates Rise

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 annual percentage yield (APY) on savings accounts and CDs to get more attractive.

Savings account and money market account rates should move up fairly quickly as rates rise.

Short-term CDs (6-12 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 are enough to keep pace with inflation. In an ideal world, you’d at least break even, and your savings would grow as quickly as prices increase. In reality, rates lag behind inflation, and income tax on the interest you earn means you’re probably losing purchasing power at the bank.

Saving Strategies for Increasing Inflation

Keep options open: If you think rates will rise soon, it might be best to wait to put cash into long-term CDs. Alternatively, you can use a laddering strategy to avoid locking-in at low rates, because 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 is also a good time to keep an eye out for better deals. Some banks will 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 really 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 to move.

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. If you lose a bit of purchasing power due to inflation, that’s the price you pay for having an emergency fund—and that might be a small price to pay. Talk with a financial planner to find out what, if anything, you should do with longer-term money.

Loans and Inflation

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 fixed-rate mortgages should get easier to handle. Of course, if your income fails to rise with inflation or 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 (LIBOR, for example). A higher rate could result in a higher required monthly payment, so be prepared for a payment shock if inflation picks up.

Locking in rates: If you’re planning to borrow soon, but you don’t have firm plans, be aware that rates may be higher when you eventually apply for a loan or lock in a rate. If that happens, you’ll need to pay 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.