Let’s say you have a $25,000 student loan (what a coincidence, I have a nearly $25,000 student loan!) on which you’re paying about 3% interest, if you consolidated about two years ago, and you’re only sending in the minimum payments because you’re coming out ahead when you deposit the rest in a 5.15% Emigrant Direct account. This is exactly what I’d be doing if my loans weren’t in deferment because of my continuing education. (feel free to substitute car loan for student loan in the example, any low interest loan will suffice)

The only problem with that thinking is that while you are you coming out ahead by 2.15% (a little more considering the interest deduction), the difference between the 5.15% savings account and the 3% student loan interest, you’re actually falling behind from a purchasing power perspective because inflation is higher than 2.15%!

Now, if we were discussing this, you’d say that if you paid out the entirety of the loan as quickly as you could, you’d in fact be making 0% on that money because you would no longer possess it. That is true, however, by accelerating your payments you are setting yourself up to be debt free in the future and thus able to freely invest what you would’ve had to earmark for student loan payments. [Also remember that this superficial analysis ignores all other factors because we often can't make large payments on our student/car loans because we have other financial obligations like mortgages/rent, food, emergency funds, etc. that take precedence, but for the sake of argument from a strictly mathematical perspective I ask that you leap with me.]

So, how is this different than the 0% balance transfer arbitrages that many personal finance bloggers (including myself) have started? How does a 3% car loan differ than a 0% credit card loan outside of the interest rate? The difference is the 0% balance transfer is the source of the interest bearing funds whereas with a car loan the source of the interest bearing funds are your own savings. 0% balance transfer money is a bonus.

I’m eager to hear everyone’s thoughts on this because for the longest time I was of the mindset that you should just pay the minimums, deposit the rest, and collect your difference in interest because you’re making more than 0% on your money. The floor of what you should demand on your money should be the inflation rate, which is much more than 0%.

Don’t expect to see that on a t-shirt or anything (let me know if you do!) but inflation is hurting our poor defenseless pennies. We all know what inflation is, but most of us don’t really think about it on a daily basis; even when we’re making our most important financial decisions. It’s those stories you hear about a pack of gum cost 5 cents back in the day and now they cost fifty cents or more; that’s inflation, or the erosion of our currency’s purchasing power.

Let’s ignore the bigger macroeconomic issues as to why inflation exists and whether it’s good or bad, because honestly I don’t think most people care. We can let economics and policy makers analyze those aspects because it matters to them (it better!). For us little people, let’s talk about how they measure inflation. There are two indexes (indices if you prefer) most people talk about: the Consumer Price Index (CPI) and the Producer Price Index (PPI). They are the big indicators and the US Bureau of Labor and Statistics tracks them both. In summary, the CPI tracks price changes with respect to the consumer and the PPI tracks them with respect to the producer. They say in the long run the two trend similarly but in the short term the PPI will lead the CPI (which follows intuition, producers raise prices before consumers feel them). Well, when the Federal Reserve meets (8 times a year) to decide whether or not to adjust the short term interest rates, the CPI/PPI is a factor they take into consideration.

Well, how does this affect me/you? Basically, your investment’s true return is really its stated return minus inflation and taxes. Nearly everyone accounts for taxes because you take money out of your pocket. Inflation is an invisible tax because you’ll just lose purchasing power, not actual dollars.

But I don’t invest a lot of money; where else will this affect me? Your salary! Are you happy with that 2% raise? You would be if everyone around you also received a 2% raise (or less), but what if I told you the historic rate of inflation was 3.257% since 1913 (according to the inflation calculator on the USBLS website)? That meant if our rate of inflation this year were 3.257%, you actually took a purchasing power pay cut of 1.257%!

We arrived at 3.257% because in the 92 years since 1913 (to 2004), $100 (1913 dollars) is now worth $1908.08 (2004 dollars), or a 3.257% annual increase.

How do the interest rates of ING Directrel and Emigrant Direct sound now? How about that bond? When you have to beat 3.257% CPI-based historic inflation rate, it doesn’t look as appealing huh? Look at some of the actual historic rates and you can see that in some years the rates were much higher (though you would expect rates of return for CDs, bonds, and the like to be much higher as well). So think about the rate of inflation next time you make any sort of financial decision, it’ll open your eyes.