How Inflation Impacts Your Interest Income

By Subodh / November 28, 2015

Inflation is something that affects virtually everything in the economic world. As a prudent investor – you will have to be on your guard to understand its true impact and consequences for your personal investment portfolio. An investor may have several different asset classes in his portfolio. One of these is the investments made in debt or bonds.

Debt as an Asset Class

It is worth considering the features of debt as an asset class before considering the impact of inflation on this asset class. Now, as is fairly well recognized, debt is an asset class that is available to an investor in addition to other asset classes such as equity, real estate, commodities, etc. The debt is primarily a loan that is lent by one party (creditor or investor) to the other party (debtor).

Debt Mutual Funds

Interest as a Return on Investment

One of the most important features of debt as an asset class is the nature of the return that will accrue from it. Again, as is well known, debt as an asset will pay the creditor (investor) a pre-determined sum of money at a pre-determined interest rate upon the lapse of specific durations of time. This return is thus the interest that becomes payable on account of the loan – usually – on a quarterly, half-yearly or annual basis. The loan itself is not payable in its entirety immediately. It will mature fully only upon the completion of the full tenure of the loan – and at that point – the principal amount becomes payable in its entirety.

Why Certain Investors Prefer Debt as an Investment Asset

The reason that a number of people prefer the debt as an investment asset is because of the promise of guaranteed interest payouts at specific durations during the tenure of the loan. For such investors – it is the predictability of such payouts – at the lapse of specific periods of time – that is valuable. Hence they prefer to invest in debts as an asset class.

The Impact of Inflation on Interest Income

As is widely understood today, inflation refers to the gradual increase in the price of goods and services over time. There are a number of theories on what causes inflation. However, these are not really relevant to us for this discussion. What is important to note is that inflation affects the interest income from debt assets very profoundly. Let us discuss an example to understand this further.

Illustration of the Impact of Inflation on Interest Income

inflation

Assume that the debt asset you are investing gives you 5% interest per annum. Thus $ 100 would give $ 5 as interest. Let us now introduce the other variable. Let us say that the inflation rate for a particular year is also 5%. What this implies is that the same set of goods and services have now become 5% more expensive in one year. Now, we all have to factor this into our calculation of the interest income being earned by the 5% interest rate. Only when you factor in the external inflation, will you be able to assess the true and real situation regarding the value of the 5% interests your debt asset is earning. Now, in our example, your debt asset is earning 5% per year. However, in order to calculate the real value of the interest earning we will have to subtract the inflation figure from it. Now, since the inflation is running at 5% per year, in effect the earning from this debt asset is zero.

A Prudent Investor and Inflation

As you can tell from this example – inflation has a profound impact on interest income. Only when the interest income is more than the inflation during that particular year there is an effective positive earnings from that debt asset. Otherwise, there is no effective earning. All prudent investors will have to carefully monitor the inflation rate on a yearly basis and then factor that into their determination of the real income from their interest-earning debt asset. Whenever the asset does not provide the investor with the planned return – the investor would have to tweak his or her investments further to ensure that their investment and saving plans are on track and reliable.