What is inflation and how does it affect my savings?
You can’t get through the news these days without hearing about inflation and how rapidly it’s increasing. Rates were generally low for quite some time and we all got used to it. Suddenly, however, everyone is getting squeezed by inflationary pressure.
But what exactly is inflation, and how does it affect the money you have in the bank? Read on to learn more about what it is and what it means for your savings.
What is inflation?
Inflation is an increase in prices. Everything from a can of soup to a home costs more to buy. Of course, not all goods get more expensive at the same rate, and there are many reasons why prices go up.
Year after year, things are more expensive than they were before. You’ll see this in action if you look at an old advertisement from 100 years ago. Things that used to cost a bit of change now cost much more.
This is purposeful to some degree. Economists generally agree that a target rate of 2% annually is desirable to keep balance in the economy and promote growth. This rate allows central banks to lower interest rates to stimulate the economy if necessary without putting too much of a burden on the consumer.
What causes inflation?
The factors that cause inflation are varied and somewhat complex. There are a few different types of inflation as well. Supply and demand, production costs, worker shortages, printing money, and rising wages – all of these factors and more contribute to inflation.
When the entire picture is considered, you can see why understanding any given inflation situation becomes a matter of healthy debate. While it’s clear that we as individuals have little control over inflation, we all want to know what it means for our bank accounts.
Any time your savings grow slower than the inflation rate, you will effectively lose money. Put simply, the money in your savings account must earn a higher interest rate than the inflation rate to continue to hold the same value.
Currently, the global inflation rate is a few percentage points higher than the average savings account pays in interest. So while you have the same dollar amount in your account, that money now buys less than it could when prices were lower.
The “Rule of 72”
One interesting way of estimating how the inflation rate will affect your money is known as the Rule of 72. While it’s only to be used as a general estimate, it can help you imagine what will happen to your money if rates continue at their current level.
To determine how long your savings will take to double, take 72 and divide it by your annual interest rate. For example, if you hold $100 in a savings account with a 2.5% interest rate, it would take 28.8 years for that account to reach a balance of $200.
You can also use the rule to calculate how quickly these new higher prices would halve the value of your savings. Take 72 and divide it by the annual rate of inflation. If it’s currently 6.5%, for example, it would take just over 11 years for your $100 to be worth $50.
You can see why an inflation rate higher than the interest you’re earning is problematic. While your actual dollar amount will continue to rise, inflation will undercut those earnings by making each dollar worth less.
Remember that this is only a general estimation and doesn’t consider many factors. For example, it’s unlikely that the inflation rate would remain the same for 11 years or anywhere close to that. The Rule of 72 is only meant to illustrate the pace at which your money changes – to help understand the gap between the two rates.
It’s easy to get caught up in the talk about inflation and how it devalues your money, but try to remain calm. Remember that while prices may never go down to what they once were, periods of high inflation have happened before, and they will happen again. However, they don’t last forever, and by continuing to make educated choices about where to invest your money, you will successfully weather the storm.