How to Handle Debt as Inflation Spikes
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Inflation is one of those things where it doesn’t seem like you can do much to change it. You have no control over fuel shortages, supply chain issues at the grocery store, or what the Federal Reserve does to lower inflation and get higher prices back in line.
All of that’s true. But there are some things you can do as an individual to deal with inflation so that it has less effect on your finances. Debt, especially, can be challenging to deal with as inflation nears 40-year highs.
In this article
What the Federal Reserve is doing
Understanding what the Federal Reserve is doing to lower the inflation rate can help you better deal with debt and inflation overall.
The Federal Reserve is raising interest rates to lower inflation and avoid a recession.
Here’s how bad inflation is: As of mid-2022, the annual inflation rate in the United States was 8.3 percent. Inflation started taking off in 2021 when it was 7 percent. It was a lot lower in the previous 20 years, hitting a high of 3.8 percent in 2008, to a low of -0.4 percent in 2009, called negative inflation, or deflation when the supply of goods exceeds demand.
The Fed’s job is to keep inflation under control and maximize employment. It raised interest rates in March for the first time in four years to control inflation. Higher interest rates mean higher borrowing costs, such as through credit cards. Combine that with high inflation lowering your purchasing power, and the fear is a recession could happen.
You’ve probably seen the effects of inflation in your daily life. Prices are rising everywhere. Gasoline, food at the grocery store and in restaurants, cars and trucks, and clothes are some of the main areas where prices have skyrocketed.
Some economists say that the Fed raising interest rates to get prices more under control should eventually work, but it could take a year or so. Until then, there are some things consumers can do to help ease the pain of inflation.
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Handling debt as inflation spikes
It may be hard to consider when you’re in debt, but paying off your debt can free up your money for other uses. You can have more money for savings accounts, investments, vacations, and even necessities like groceries by eliminating credit card debt, for example.
Here are ways to handle debt during high inflation and rising prices.
1. Pay off variable debt
Paying down debt before interest rates rise can mean saving money you’d typically pay at higher interest rates. Variable debt such as credit cards, lines of credit, personal loans, and variable rate mortgages is worth paying down to handle inflation because higher interest rates will only make those loans more expensive.
Fixed-rate mortgages and other fixed-rate loans will likely increase with changes by the Fed, but existing borrowers won’t see their rates change.
If you can find lower loan rates than what you already have, then it’s a good time to refinance whether inflation is high or not.
Credit card debt can be some of the most expensive variable debt around. Credit card interest rates average 16.45 percent and can reach 25 percent or higher for people with poor credit scores. You’re unlikely to earn a higher rate through investing.
Another way to spend less on credit card debt is to switch to a credit card with an introductory 0 percent APR, or annual percentage rate. Balance transfer cards are usually offered to people with good or excellent credit, so you may not qualify. If not, you may still be eligible for a different credit card with a lower interest rate. Either method leaves you with lower interest rates.
2. Cut expenses
Tacking debt isn’t the only way to win a little as the cost of living increases. Creating a budget and cutting expenses can help you stay out of debt. A credit card can easily be used to pay your daily bills, so cutting expenses can lessen the temptation to add debt.
Tracking your spending can help you find areas that can be cut, such as subscription services and dining out often. Switching from name brands to generic at the grocery store can save you money as current inflation rates go up. High gas prices may encourage you to drive less and take public transportation.
3. Prepare for emergency expenses
After paying off as much debt as possible and cutting expenses, it’s a good idea to set up an emergency fund. Less than half of Americans have enough money to cover a $1,000 emergency expense. And if a recession arrives, you’ll likely face an emergency expense.
Ideally, you should save at least three to six months’ worth of living expenses in an emergency fund in case you lose your job. Keep the money in a high-yield savings account, which still won’t beat inflation, but that isn’t the point. The goal is to keep your household running when times are tough.
According to a Forbes survey, nearly 7 in 10 Americans are raiding their savings as prices for goods and services rise. Using savings to pay for higher prices for gas, food, and just about everything else isn’t ideal, but it beats the alternative of paying for them with credit cards.
Savings accounts offer quick access to your money, which you want in an emergency fund, but the low risk isn’t rewarded much. Even high-yield savings accounts pay only about 1 percent interest. Certificates of deposit (CDs) for mid- or long-range goals of a year or more often offer higher yields than savings or money market accounts.
Related: How to Start an Emergency Fund
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Where to put your money
Getting out of debt during inflation spikes is a good idea, especially if you have credit card debt because when the Federal Reserve raises interest rates, it directly affects credit cards.
But if you have money to invest after cutting back debt, the stock market can be a good hedge against long-term inflation, though inflation spikes can cause short-term pain.
One of the best places to invest during high inflation is in Treasury Inflation-Protected Securities, or TIPS. These are backed by the U.S. federal government and are a good way for people on a fixed income to beat inflation.
They protect against inflation, with the principal increasing with inflation and decreasing with deflation, as measured by the Consumer Price Index. When a TIPS matures, you’re paid the adjusted or original principal, whichever is greater. Interest is paid twice a year at a fixed rate. TIPS are issued in terms of five, 10, and 30 years.
Costs
If you move a credit card balance to a card with an introductory 0% APR, be aware that most cards charge a balance transfer fee of 3 to 5 percent of the amount you’re transferring. The move may still be a deal, especially if you get a year of no interest charges and can pay it off before the 0% interest rate expires.
To avoid costs on an emergency savings account, look for a bank that doesn’t charge a monthly fee when you meet a minimum balance amount. Your existing bank may offer you a savings account for free, or many online banks have free accounts.
Related: How to Recession-Proof Your Savings
Pros and cons
Pros
- Eliminating debt is one of the best ways to beat inflation. As the Federal Reserve raises interest rates, credit card interest rates will also rise, causing payments to be higher if the balance is paid off in full each month.
- Paying off variable debt will eventually leave you with more money to save or spend elsewhere.
- Handling your debt during inflation spikes may cause you to look at other ways you deal with money, such as having an emergency account and starting a budget.
- One way to lower your debt is to have fewer expenses. Inflation spikes can be a good time to review renewing subscriptions and other costs to which you may not pay close attention.
Cons
- The hardest part of paying off variable debt is finding the money. This may require taking on side gigs, working overtime, and cutting expenses.
- Many people put money in savings accounts during the pandemic. But to deal with inflation and higher prices, many are now withdrawing some of it to pay their bills. This could lead to lower emergency fund balances, which may be needed in a job loss.
- Efforts by the Federal Reserve to lower inflation can take a year to take effect.
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The bottom line
Paying down debt is one of the main things consumers can do during inflation spikes, and it’s one of the concrete steps they can take to see changes in their finances when prices are rising all around them.
If you can afford it, paying down credit cards and other variable debt is smart because interest rates on such debt can change monthly and are likely to rise as the Federal Reserve raises rates. With less debt, you’ll have more money for living expenses and an emergency fund.
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Writer
Aaron Crowe is a freelance journalist who specializes in personal finance writing and editing. He has worked at newspapers, where he won a Pulitzer Prize, and has written for numerous online publications. These include AOL, US News & World Report, WiseBread, Bankrate, AARP, and many websites focusing on housing, credit and insurance. He lives in California with his wife and daughter.
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