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What is the Effect of Inflation on Existing Loans?

Our period of low inflation could soon be a thing of the past thanks to several economic factors. On Dec. 8, 2018, the Labor Department released its monthly figures showing that 228,000 new jobs were added in November, which represents 86 months straight in which employers have added jobs. Unemployment is now at 4.1 percent, which is the lowest rate since 2000.

Congress has proposed a $1.5 trillion tax cut this month, which could bring additional growth to the economy. In fact, some economists believe that the economy could grow too fast, which will solve that sluggish inflation problem and leave us with figures much higher than desired. Whether that happens or not, inflation impacts more than the price of a quart of milk. Here is how different inflation levels can have an effect on existing loans.

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Inflation refers to changes in relative purchasing power over a period of time. In closing out 2017, we could see the sixth straight year where inflation has remained below the Federal Reserve's 2 percent target. While employment levels have increased, wage hikes are barely outpacing inflation. In the past year, average hourly wages are up just 2.5 percent based on November's numbers.

A borrower that has an existing loan will be impacted differently based on the type of loan and the level of inflation.

Variable Rate Loans and Inflation

When inflation spikes, increases in interest rates usually aren't far behind. Lenders prefer variable rate loans because they can compensate for inflationary changes. When a lender prices a loan, they do so with the anticipation of a certain rate of inflation so that they can make a desired profit on the loan. If inflation doesn't materialize, long-term loans could be less profitable.

A borrower that has a variable rate loan is going to find that their payments will often go up with inflation, which could continue to climb if there isn't a cap built into the terms of the loan. When borrowers don't plan for these increases, there is a chance that they won't be able to make payments and will default. This is particularly the case if wages don't increase in tandem with inflation.

Inflation and Fixed Rate Loans

Inflation can also have an impact on existing fixed-rate loans. Assuming inflation rates begin to go up, a borrower will find that their fixed-rate loans have become more affordable. For example, a borrower has a fixed-rate auto loan at 5.25% that gives them a $320 monthly payment when the prime rate is 4.25%. If inflation prompts a prime rate increase to 5.5% over two years, that same auto loan is now below the current prime rate. Not only is the existing loan more affordable, but usually wages also increase with inflation which provides the borrower with more purchasing power.

When inflation is low, purchasing power diminishes. A borrower with that same $320 fixed-rate loan payment might find that they aren't able to make the payments because it's become a larger part of their expendable income than it was in the past. Assuming interest rates go down, this is good news for lenders who have borrowers locked into higher rate loans. There is also the possibility that some borrowers may either refinance or default on their existing loans.

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Partner With an Asset Management Company to Maximize Profits

Whether inflation increases or not in the coming year, the Federal Reserve has announced its intention to continue raising interest rates. The Fed met on Dec. 13 and, predicting modest economic growth from the impending tax cut, elected to raise the benchmark rate by another quarter of a percentage point to 1.5 percent.

In 2018 and beyond, some existing loans will be more profitable than others, and some asset classes may become distressed. One way to both minimize loan portfolio risk and maximize profits is to partner with an asset management company that specializes in buying and selling loans. Depending on the state of the market, a lender can quickly optimize their portfolio as conditions change.