Inflation: How It Affects Your Finances
Have you ever felt like your money just isn’t stretching as far as it used to? Week in week out, you buy the same things, yet the bill seems to be increasing! This could be due to inflation.
What is inflation?
Simply put, inflation is the increase in the prices of goods and services over time. With increasing inflation, you can buy less with €1 today, than you could buy yesterday.
Inflation is measured by tracking the prices of a basket of selected goods and services over time. This basket may include everyday goods such as food, more durable items such as home appliances, as well as services such as insurance. These goods are selected based on the typical purchasing habits of people in a particular country. An increase in the prices of these items results in an increase in inflation.
One of the objectives of the European Central Bank is to keep the level of inflation in the European Union around 2%. The average level of inflation in Malta was that of 6.1% in 2022. The rising level of prices is attributed to the current economic and political scenario.
Inflation impacts consumers in many ways. As the cost-of-living increases, you will pay more not only for goods but also for services, such as rent. As a result, while your salary remains unchanged, you’ll find that your purchasing power (i.e., what you can actually afford to buy with your salary) reduces, and you’ll be able to save less money.
If you are saving money in your bank account, you should understand that inflation can erode the real value of your savings.
When it comes to loans, when inflation goes up, the actual value of your loan decreases over time. If you have a fixed interest rate, you will always pay the same amount, so the actual value of your repayment will decrease over time. On the other hand, variable interest rates are determined by benchmark rates, which may increase due to central bank actions to combat inflation. Borrowers with fixed interest rates benefit from inflation, while borrowers with variable interest rates are penalised.
Practical Example: If you borrowed €1000 from a bank with a fixed interest rate of 2% one year ago, you would have paid a lower interest rate compared to borrowing the same amount today due to the higher level of inflation.
The mechanism here is actually the same as what happens in the case of loans; however, in this scenario, you are a lender rather than a borrower! If you have invested in a bond, you are ‘lending’ money to the Company who has issued the bond, and you are expecting an interest rate in return. With fixed interest rates, you will always get the same amount. With variable interest rates, you can benefit from higher interest rates.
When you insure your home, whether it is buildings or contents or both, you are required to advise your Insurer of the sum insured. The sum insured is the total amount of money for which you are covered, and the insurer charges you an insurance premium based on this declared sum insured.
If you get this insurance value wrong and it is lower than the real value at risk, then your premium will be based on the wrong value and will be lower than you should have paid to cover the property at risk.
Home policies would usually contain a Condition of Average. This means that the amount received on your claim will be reduced proportionately to the sum insured. Simply put, the Condition of Average says that if, for example, you declare an insured value that is 70% of the total cost, you will only be paid 70% of the claim and you will have to bear the balance of the loss yourself.
In particular, pay attention to buildings insurance required by Banks for a loan when purchasing a property. It is very important that the sum insured of the property subject to the home loan, is regularly updated as the value of the property increases, because if you become under-insured, claim payments will be reduced as described above. You may consider consulting with an architect or building surveyor to determine the appropriate sum insured for your property.
Practical Example: Imagine you have insurance for a building with a sum insured of €70,000. If you suffer a loss and the actual value of the building at that time is €100,000, you can only claim 70% of the loss because of a condition called “Average.”
For example, if your loss is €5,000 and your policy excess is €125, your claim will be reduced to €3,375 after applying the 70% Average and subtracting the policy excess.
No. In general, a moderate level of inflation indicates that the economy is growing and is in a good state. If consumers are generally employed, they have enough money to buy goods and services. This leads to a strong demand, which eventually pushes prices up.
There’s no easy solution to inflation, but we can take steps to lessen its negative effects. With rising inflation, central banks, such as the European Central Bank, may increase interest rates. This means borrowing money will cost more, but investments in commodities, stocks, and real estate could become more profitable. Keep in mind that many factors can affect investment outcomes, and inflation is just one of them.
One way to protect yourself from the negative effects of inflation is by investing in assets that have a positive relationship with rising interest rates. You should also keep an eye on the inflation rate when you borrow or save money to make informed decisions and better manage your finances.