When people are considering borrowing money, one of the key features they examine is the interest rate on the loan. Is this the only factor that’s important when looking at what loans will cost? N.C. State University economist Mike Walden answers.
“Well, certainly not. … We also want to look, for example, at loan terms, like how long you have to repay the loan, fees for the loan, as well as any other kind of requirements like size of down payment. But another factor that perhaps people don’t think about, which economists do, is we need to consider inflation.
“And really what higher inflation does is effectively reduce the cost of repaying the loan. That is, because as you repay the loan over time, if inflation’s going up faster, those dollars are worth less. So higher inflation effectively reduces the cost of borrowing. Therefore, when you’re looking at, for example, the interest rate that you pay on a loan, really what you want to do is take that interest rate and then subtract off expected inflation rate over the life of loan. You could use the current inflation rate, and that’s going to give you something economists call the real interest rate.
“And incidentally what the Federal Reserve is doing now by, I think, potentially trying to push inflation up — they’re actually trying to reduce those … real interest rates.”Category: Economic Perspective