Inflation usually occurs when there is more supply of money within the economy, leading to a decrease in relative value of currency. It causes an increase in the prices of goods and services within an economy.
As a result, a country makes changes in their monetary policy with the aim of suspending the flow of money. These changes have a direct impact on the lending rate. Inflation affects borrowers and lenders both due to changing value of currency and resulting changes in monetary policies.
Inflation affects borrowers both negatively and positively, depending on the stage of their borrowing.
If high inflation comes with a simultaneous increase in employee wages, it would be easier for you to pay off your existing debt. This is because the existing EMI amount will remain the same. Further, you will have more disposable money due to the salary hike.
Again, if your liabilities remain unchanged as the relative value of money decreases, it will be more profitable for you. You can understand this phenomenon with an example. Let’s assume that the price of milk before and after inflation is Rs. 50 and Rs. 70 per litre, respectively. However, due to a past contract with buyers, you are buying the milk at Rs. 50/litre, even after inflation. Therefore, it can help you save Rs. 20.
The same happens with a debt obligation. Despite the relatively deflated value of money, you will pay off the debt as per your contract made with lenders.
Inflation does affect the borrowing experience as financial institutions increase their lending rate during this time. As a result, you need to pay more towards the interest component. Further, in such a situation, you borrow when you have more purchasing power but repay when this purchasing power is less.
Again, during inflation, credit facilities with short tenures, such as credit card principal and personal loan, can be a little more cost-effective than loans with longer repayment periods. This is mainly because you borrow at a higher interest rate in times of inflation. If the tenure is high, you will have to keep on repaying with the same instalment amount, even when the lending rate decreases after inflation slows down.
Let’s assume that you have taken a home loan of Rs. 50 Lakhs at an 11% interest rate for a period of 12 years when the inflation rate was 10%. Nevertheless, after 2 years, when the inflation rate decreases to 5%, the home loan interest rate also reduces to 8%. Due to this 3% higher interest rate, you will end up paying more than Rs. 12 Lakhs towards interest.
Inflation can have an adverse impact on lending institutions. To tackle inflation, a country increases the Repo Rate, Current Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) etc., to curb the overall flow of money within the economy. As a result, the cash flow of financial institutions reduces.
Furthermore, due to the higher repo rate, they have to pay more interest for borrowing short-term liquidity from the central bank. In response to this, they increase the commercial lending rate to maintain their profitability.
Thus, Inflation affects borrowers and lenders due to changes in the country's policies for curbing the overall flow of money. Due to increased Repo Rate, loans become costlier for new borrowers. Nevertheless, borrowers who have taken loans before inflation stay at an advantage as their interest rates and EMIs remain unchanged at the earlier low rates.