Why (good) debt is your friend in an inflationary environment

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IInflation has been high for several months since this summer, and it may not be as “transient” as policymakers initially thought. Federal Reserve Board Chairman Jerome Powell had a noticeable change in tone earlier this month, and former President and current Treasury Secretary Janet Yellen said it was time to stop characterizing temporary inflation.

Inflation can have a huge impact on your personal finances. When your dollar doesn’t go as far this month as it did the month before, your budget may start to feel the squeeze.

But if you’re a fixed rate borrower in a high inflation environment, you may actually come out on top.

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Low-rate debt can be lucrative

If you’ve bought or refinanced a home in the past 1 1/2 years, you’ve probably received a mortgage rate that previous generations would consider unfathomable. It’s not just mortgages. Car loans, student loans, personal loans, and any other type of loan you can think of have very low interest rates right now.

Thank the friendly policies of the Fed, which set the target federal funds rate to 0% to 0.25% and held it there as stocks rebounded to valuations not seen since the dotcom bubble. As a result, the yield that bond buyers were willing to accept fell to historic lows.

If you can lock in a long-term fixed rate loan right now, that’s a smart financial move.

The average home loan is currently well below 4%. Inflation over the past year was well over 6%. At these rates, the real effective interest rate is negative. In other words, anyone with a reasonable mortgage has more buying power today because they have gone into debt over the past year.

I’m not saying you should go out and acquire as much long-term fixed rate debt as possible. But if you can use debt to fund purchases you’ve planned to make anyway, it will benefit your finances immensely in an environment of high inflation. And if you currently have debt like a mortgage, student loan, or low-interest car loan, don’t pay a penny more than your minimum monthly payment.

What to do with extra capital

The only challenge with holding on to extra capital instead of paying down debt right now is that you can’t just leave it in a savings account. With the overnight rate still hovering around 0%, most banks aren’t willing to pay much more than that on your deposits. You will get a better real return by paying off your debt, even if the interest rate is extremely low.

You need to invest your additional capital, and this will require taking some degree of risk. But here are three things you should consider doing with any extra capital instead of paying off debt.

You can invest in Series I savings bonds. Series I Savings Bonds have a variable interest rate adjusted every six months for inflation. The latest adjustment fixed the interest rate at 7.12% until April. The rate will adjust again in April based on the rate of inflation at that time.

Series I bonds will protect your money from the forces of inflation. Any interest paid on the bonds is exempt from state and local taxes, but you will pay federal income tax, which lowers your effective interest rate. Instead, they require you to freeze your money for at least a year and charge you a three-month interest penalty if you withdraw before five years. You are also limited to purchase for $10,000 per person per year.

Another option is to simply add to your investment portfolio. Over the long term, you should expect your portfolio to outpace inflation. That said, with market valuations where they are today, actual returns could be much lower than they have been in the past.

Finally, if you’re not already maxing out your retirement accounts, they’re a great place to stash your extra funds. The additional tax benefits of contributing to your retirement funds can help boost the returns you get from investing. The only downside is that capital is mostly tied up until retirement age, although there are creative ways to access these funds sooner if you need it.

Holding a lot of fixed-rate, low-interest debt is actually a solid financial position for now, assuming you can easily make the payments and have extra money left over each month to invest. As long as inflation continues to be high, you shouldn’t be paying off any additional debt. Instead, use the extra money to invest so you have more buying power in the future.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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