Learn How Inflation Affects Lending And Credit

How does inflation affect lending and credit

The current economic climate is challenging for families and people across the UK. In the wake of the worst of the pandemic, the cost of living has increased in many areas. In response to these pressures, now more than ever is a great time to improve our financial knowledge and capability. Today, the Everyday Loans team is going to cover a critical aspect of financial knowledge: interest rates and inflation. These two things affect lenders and their decision to offer credit. They can also affect your personal finances.

Inflation has been in the news recently as prices on many necessities have increased so this is the perfect time to discuss how it can affect you.

How does inflation get measured?

As we’ve covered in recent articles, the main way in which inflation is measured is through what is referred to as the ‘consumer prices index’, or CPI for short. This is a set of measurements that are managed and reported on by the Office for National Statistics (ONS).

In short, CPI is determined by the measurement of the rise and fall of a core set of goods in the UK. These are essential items for most people and households, such as fuel and food staples. In total, the price of approximately 180,000 items is checked. [TW1] These combine to give a reliable and informative figure upon which to measure the financial status of the UK.

In addition to the CPI, the retail prices index (RPI) is used to similarly measure inflation. A major distinction between the CPI and the RPI is that the latter includes mortgage interest payments in its calculations.

Interest rates: An important metric

The bank rate or base rate, as it is sometimes referred to, relates to the interest rate that is regularly determined by the Bank of England. This is an exceptionally important figure that is adjusted by the Bank in response to the economic status and performance of the country. At present, it’s increased from 0.25% to 0.5%.

While this might appear a small difference, it has profound knock-on effects on the performance of the economy and the financial security of people in the UK. Bank rates are a vital metric that heavily impacts other major economic functions in the country. This includes how expensive loans and mortgages are to repay, and the amount of interest that people with money in their banks receive. Bank rates are calculated every six weeks by a body known as the Monetary Policy Committee, or MPC for short. With the recent increase in the bank rate occurring on the 3rd of February 2022, the next reappraisal is due on 17 March 2022.

Inflation and interest: How they interact

One of the most important things to know about these two things and how they work together is that they are in what is often called an ‘inverse relationship’. This means that generally speaking, when one of the two rises, the other will fall.

The Bank of England generally tries to keep inflation at approximately 2% per year. Achieving this level of inflation helps to keep the economy on an even keel, with a modest and consistent amount of inflation reflecting a sturdy economy.

Knowing this, we can think in hypothetical scenarios to help us learn and understand more about how inflation and interest interact. Let’s say we have a period in the UK’s economy where the interest rate is decreasing. In most cases, when the interest rate decreases, borrowing of various kinds rises. This is because banks tend to charge less interest for loans so borrowing is cheaper for everyone. With interest rates going down, borrowing becomes more affordable so people and businesses are more likely to take loans or other financing. This subsequently leads to an increase in the inflation rate as more goods and services are purchased.

It's always helpful to keep in mind that one mission of the Bank of England is to maintain an economy that is steady. This means doing what they can to avoid sudden spikes and falls in the financial wellbeing and activity of the country. Interestingly, a sudden spike of growth can be a challenging thing to manage; if the economy is growing rapidly, it’s often the case that the Bank of England will increase the interest rates to avoid an uncontrolled surge in spending – and to lower the inflation rate.

Interest rates and loans

In most cases, an increase in interest rates shouldn’t affect people who already have loans that are in place and ongoing – monthly repayments should remain the same. This is because the Annual Percentage Rate, or APR, is calculated and set at the time of requesting and taking out a loan. Even if interest rates increase, you should be just fine with the loan you have in place already.

If you are considering taking out a loan, changes to interest rates by the bank of England can be a double-edged sword. If rates rise you could pay a higher APR for your loan, if they fall, you could get a better deal. It is also important to remember that some loans have a variable rate which means your monthly costs could fluctuate depending on any interest rate changes.

We’re going through unique and challenging economic times right now in the UK and the wider world. It’s a great time to ensure that your financial awareness and planning are up to scratch.

[TW1]https://www.ons.gov.uk/economy/inflationandpriceindices/articles/ukconsumerpriceinflationbasketofgoodsandservices/2021