Please ensure Javascript is enabled for purposes of website accessibility

Why (Good) Debt Is Your Friend in an Inflationary Environment

By Adam Levy – Dec 14, 2021 at 1:06AM

Key Points

  • Today's high inflation may not be as transitory as policymakers initially thought.
  • If you're a borrower, you may be receiving a negative real interest rate.
  • Instead of paying down debt, invest to increase your buying power.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Don't be in such a hurry to pay off your low-interest loans.

Inflation has been running high for several months since this summer, and it might not be as "transitory" as policymakers initially thought. Federal Reserve Board Chair Jerome Powell had a noticeable change of tune earlier this month, and former Chair and current Secretary of the Treasury Janet Yellen said it's time to stop characterizing inflation as temporary. 

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

But if you're a borrower at a fixed rate in a high-inflation environment, you can actually come out ahead.

A person sitting at the kitchen counter looking at a laptop and bills.

Image source: Getty Images.

Low-rate debt can be a moneymaker

If you bought or refinanced a house in the past 1 1/2 years you likely received a mortgage rate 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 has a very low interest rate right now.

Thank friendly Fed policies, which set the target federal funds rate to 0% to 0.25% and kept it there while stocks rebounded to valuations not seen since the dot-com bubble. As a result, the yield that bond buyers were willing to accept went to record low levels.

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

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

I'm not saying you should go out and acquire as much long-term fixed-rate debt as you can possibly qualify for. But if you can use debt to finance purchases you planned to make anyway, it's going to benefit your finances tremendously in an environment with high inflation. And if you're currently carrying debt like a mortgage, student loan, or car loan at a low interest rate, do not pay a penny more than your monthly minimum payment.

What to do with extra capital

The one challenge with holding onto 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 sitting around 0%, most banks aren't willing to pay much more than that on your deposits. You'd be getting a better real return by paying off your debt, even if the interest rate is extremely low.

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

You can invest in Series I savings bonds. Series I savings bonds have a variable interest rate adjusted every six months, based on inflation. The most recent adjustment put the interest rate at 7.12% until April. The rate will adjust again in April based on the inflation rate at that time.

Series I bonds will protect your cash from the forces of inflation. Any interest paid on the bonds is exempt from state and local taxes, but you'll pay federal income tax on it, which reduces your effective interest rate. On the downside, they require you to lock up your money for at least one year and impose a penalty of three-months interest if you withdraw before five years. You're also limited to buying $10,000 worth per person per year.

Another option is to simply add to your investment portfolio. Over the long run, you should expect your portfolio to outpace inflation. That said, with market valuations where they are today, real returns could be much lower than they've been historically.

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

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

The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.