Effect of inflation on lending
Recently, I came across interesting economic phenomenon when inflation hits the economy. Usually when you lend someone money, you expect to get the exact amount back plus any interest. This is acceptable under regular circumstances, but when inflation hits, the purchasing power of money greatly reduces and if such money is returned during dire inflation times, the lender is in trouble.
Imagine you lend someone $100 and charge them 10% interest rate. So after a year, borrower will return $110 back to you. This is great. But imagine inflation rate goes 100% and the purchasing power of $100 is reduced to $50, but in theory, lender gets $110, but in practice they only get $60 back. This is even terrible when $100 becomes $1M and inflation rate is as high as that in Germany after WW1, what we had in Zimbabwe few years earlier or what is happening in Venezuela right now, then money borrowed before inflation is essentially becomes worthless.
How do typical lenders tackle this problem?
Generally, lenders keep their interest rates in sync with inflation rate. So when you get a loan from Bank, you see the nominal interest rate on borrowed capital. This is just an interest rate irrespective of current inflation rate. However, what you have to pay back is calculated based on the real interest rate.
Real interest rate = Nominal interest rate + Rate of inflation
For example, if you're borrowing money at a nominal interest rate of 3.5 and inflation rate is, 10.5, your real interest rate is 14% and you owe this much interest rate on borrowed capital. Because purchasing power of money has reduced, bank is charging you more on top of nominal interest rate in order to compensate for reduced purchasing power of money.
How does it affect stable and inflation prone economies?
Whenever lenders know that there is looming threat of inflation, they are cautious to lend money for long-term with fixed-interest. In that case, they add a buffer while offering a long-term fixed-rate interest. When bank knows, the central bank authority is serious about preventing inflation, they are more comfortable providing fixed interest rates for long term.
On the contrary, if the country is inflation-prone, lenders are hyper-cautious and provide variable interest rate (Which fluctuates as per the inflation rate) in order to make sure they do not lose money in the long term.
Summary
Nobody likes Inflation and hyper-inflation but they're inevitable in continuous economic cycle. So next time when you lend someone money for long term and you know there is possibility of inflation, make sure to add variable interest rate. If you are optimistic about future outlook of economy and you know the economy will be more or less stable, go with the fixed interest rate or at least add some buffer to compensate with the sudden surge in inflation.
