What’s the real benefit of taking loan when interest rate is lower than inflation

Question

This question is particularly regarding taking out a loan for a specific purpose, let’s say buying a car.

I understand that when taking out a loan when inflation is high and interest rates are low you would be paying back less value as inflation increases, which is great. All good so far.

But I have a hard time to visualise how this benefit can be realised, unless I’m actively spending/investing the money I would have otherwise spent if I hadn’t taken the loan.

In my mind, if my spending habits are unchanged by paying outright for the car (I.e. it is easily affordable), then the only thing I am doing by taking the loan is losing money by paying the interest rate.

At the end of the loan repayments I have less money, and the same car. So what value have have I actually gained?

Answer 1

If inflation is high, that means things are cheaper (in dollars) now than later. So you can buy things cheap now and sell them more expensively later. Or you can take a vacation now and work for more money later. Or so on.

If interest rate is lower than inflation, it means you could work for (say) 4 weeks and go on vacation - or you can take a loan, go on vacation, then work for just 3 weeks to pay off the loan. You benefited by 1 week.

Or if you're more of a financial speculator, you might buy a bunch of gold certificates now and sell them later and earn higher interest than the loan. Then you benefited in actual money.

That assumes you're right about inflation of that specific thing. If you're wrong, you'll have to pay the loan and the interest but your wage won't go up, so you'll end up working 5 weeks to pay off the loan. Inflation doesn't necessarily affect all products equally - even if everything gets more expensive except for your wages (or gold certificates), it doesn't help you. So it's far from a risk-free move.

You might compare it to people who bought houses they couldn't afford during 2019, then sold them in 2021. Inflation for houses was much higher than interest rates in this period. Even though people couldn't afford the houses they still made hundreds of thousands of dollars. They could have just as easily lost that amount of money.

Answer 2

In my mind, if my spending habits are unchanged by paying outright for the car (I.e. it is easily affordable), then the only thing I am doing by taking the loan is losing money by paying the interest rate.

You are correct. It's really that simple. If you aren't spending the money then inflation isn't a factor.

unless I’m actively spending/investing the money I would have otherwise spent if I hadn’t taken the loan.

Also correct. In order for paying the interest to make sense, there must be a reason for it, perhaps:

1. As you mention you can earn a return on your money, which, after taxes leaves you with more than the price of interest.
2. You don't have an emergency fund, or you have a reason to otherwise keep some amount of money easily accessible.

Note this would be true even if the interest rate offered is 0%! There still would be no reason to take it if you have that amount of money sitting in a 0% interest checking or savings account. Though, there might be some benefit to having a car loan on your credit report if your credit history is currently thin. And, fortunately, right now it's pretty easy to find over 2% interest savings accounts, and over 3% CDs, so the 0% would probably be a no-brainer. This is likely true even when comparing it against a no-loan cashback offer that still can't compete with a 3% CD on $30K for 5 years.

Answer 3

This benefit can't actually be realized in a real world scenario. While the things you are saying are true about the time value of money, you are missing one key thing. The banks KNOW about inflation and are pricing this into your interest rate.

The only way to benefit from this is to outguess the banks on what inflation rates will be over the duration of the loan. Not very likely considering they have experts doing the prognostication on their side.

Answer 4

You can do an expected value calculation.

If you want to buy a car for $10,000 and your options are to pay up front or to get a 0% interest loan for 5 years, assuming inflation is greater than 0%, the loan payments have an expected value less than $10,000. You're getting 2022 dollars and paying the loan back with deflated 2023-2027 dollars.

Practically, it's unlikely that you're going to be able to strategically get loans at interest rates less than inflation unless we're talking about a scenario where the seller is running a promotion and giving you low interest rates rather than cash back or discounts on the merchandise you're purchasing. Markets are pretty good at pricing loans above inflation. You might get lucky and find that you took out a 30 year fixed rate mortgage when inflation was expected to be 2-3% and that now you get to repay that loan with money that's deflating at an 8-9% rate. Of course, 8-9% inflation probably has other, negative, impacts on your household budget but at least you're paying back the mortgage with less valuable dollars than you borrowed.

Answer 5

One possibility you could do if interest rate is less than a loan is taking a loan to purchase something that would hold value well and is resellable. For example, gold. Unfortunately, gold has very volatile prices, so if for example there is 5% inflation yet 3% interest rate, and if you take the loan for 50 years as a bullet loan, you still can't have a guarantee that you win, since in 50 years gold would appreciate 1.05^50 = 11.467x and loan would increase 1.03^50 = 4.3839x, so the ratio is 2.6158x. That's a typical gold price fluctuation. So if gold price would decrease by a factor of 1/2.6158, in addition to increasing 5% yearly due to inflation, you would be at a loss.

Purchasing real estate isn't better either. The Herengracht index shows that property values can drop by 80%. So you can't have guarantees that taking a loan and purchasing real estate would be a winning move.

A slightly better strategy is to purchase stocks. Stocks are a form of real investment as opposed to nominal investment like bonds. Thus, stocks are inherently inflation protected. Unfortunately, 50% drops in stock market are common and 80% drop happened during the Great Depression. So, if stocks yield 8% on average and your loan has 3% annual interest, you would need 34 years to have a good enough guarantee that your investment is winning. (But of course at 5% inflation perhaps 8% return for stocks is too low, maybe they could return far more.)

Also, do note that your loan may not be 3% forever unless you have fixed interest rate. Usually fixed interest rate is more expensive than variable interest rate. Especially if you want a really long interest rate like one that stays constant for over 30 years, it would be very expensive indeed. Furthermore, inflation won't be at 5% forever. The central banks will successfully reduce it to 2% by increasing interest rates.

So profiting from taking a loan with interest rate lower than inflation is very, very hard indeed.

One thing is certain however. If your options are to take a loan and use it for consumption, or to not take a loan, it's always better to reduce your consumption and not take a loan. Loans should only be used for investments: for example if you pay for a leasing car, it might be a valid investment to buy your own car (or it may not), and also if you live in a rental building, it might be a valid investment to buy your own house (or it may not).