I’ve got inflation on my mind.
Not because there’s been a great deal of inflation recently, but because the newspaper was full of inflation-related stories and even advertisements as I wrote this.
OK, stop yawning and keep reading. Inflation is a big influence on financial well-being, and beating inflation is a key to financial success.
Inflation is the evil twin of compound interest. In both cases, small changes each year add up to big changes over time. For example, earning 2 percent interest yearly means your money grows by 22 percent over 10 years.
Even the mild inflation seen in recent years is one reason why so many people are finding it harder to pay the bills every month. Just as compound interest grows your savings, the compounded effect of small rises in inflation drags your purchasing power down.
That’s at the heart of a recurring national debate about the minimum wage that was rekindled in the State of the Union Address on Tuesday night. It’s also a central focus of efforts to squeeze federal budget savings out of Social Security and other programs by changing the way inflation is measured.
Whether you earn the minimum wage or many times the minimum wage, if your pay hasn’t increase since 2009 (when the minimum wage last increased), then you are earning less every year. That’s because what cost $100 in 2009 cost about $107 in 2012, according to the U.S. Bureau of Labor Statistics, and that means the dollar you earned in 2009 was about 93 cents last year.
That’s inflation, and if your wages don’t keep up with inflation, then your real wages are falling.
Retirees who live on fixed incomes are acutely aware of this. Unlike the minimum wage, Social Security checks are adjusted for inflation each year, but there’s a debate about whether the inflation adjustments are too large.
Cost-of-living-adjustments, or COLAs, are inflation adjustments that keep Social Security payments and some other government benefits from declining in real terms. Recently, measured inflation has been so low that there was no COLA in 2009 or 2010, but checks increased 3.6 percent in 2011 and 1.7 percent in 2012.
Federal tax rate brackets are also adjusted for inflation, because the assumption is that people’s pay will rise as inflation rises.
Understanding the impact of inflation is crucial to long-term personal financial planning.
For example, saving money for a child’s college education is going to turn out badly unless one considers what college will cost when the child reaches college age, not what it costs today. And of course, the cost of college and other necessities, such as medical care and electricity, tend to grow well above the broader rate of inflation.
Buying a house is a good example of how inflation and the compounding effect of yearly changes affect individual finances. Although the concept was turned upside-down during the housing bubble and the meltdown that followed, it used to be assumed that a home would slowly but surely gain in value over the long term, providing some protection against inflation.
Consider this. Someone who borrows $150,000 to buy a house at today’s low interest rates, say 3.6 percent for 30 years, would end up paying more than $245,000 over the life of the loan. But if a $150,000 house increases in value by just 3 percent each year, in 30 years it would be worth more than $350,000.
It works out like that because mortgage loan balances decline over time, but the small changes in a home’s value can compound, with each increase coming on top of all the previous ones.
The catch is you might know what interest rate you’ll pay on a mortgage, but we’ve all seen how hard it can be to predict real estate values and rates of inflation.
Reach David Slade at 937-5552 or Twitter @DSladeNews.
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