How does inflation impact your credit?
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As a consumer, you’ve likely felt the impact of inflation on your wallet in recent months. The cost of various items you buy has likely gone up, with inflation lingering above 8 percent since March. For June, the government reported inflation of 9.1 percent over the year.
Among other consumer items, food prices have risen more than 10 percent, and gas prices almost 60 percent. And for clothing you are now paying 5 percent more than you did in 2021. All this might make you wonder what impact inflation has on your credit situation.
What is inflation?
Inflation refers to a rise in prices over a period of time, typically over the year, or over the month. There are various indices that measure this change, such as the Consumer Price index and the Personal Consumption Expenditure index.
Core inflation refers to inflation that excludes the cost of food and gas prices, which tend to change more rapidly. Excluding these “volatile” items makes for a steadier inflation reading. And “headline inflation” refers to inflation for all items, including food and gas prices.
The U.S is currently engaged in a fight against inflation, which has been creeping up post-pandemic. This comes about following the government’s injection of huge amounts of money into the economy as stimulus, to fight the economic shutdowns Covid caused. Both Congress and the Federal Reserve engaged in such stimulus effects. This had the impact of putting money into consumers’ pockets and driving up demand for goods.
The pandemic also impacted the working of international transportation and supply chains, so that imported raw materials were not readily available to make goods, resulting in a reduced supply of consumer items. This drove up prices too. And the Russian invasion of Ukraine in early 2022 also impacted the availability and prices of agricultural commodities and gas.
How does inflation impact your wallet?
Although officials initially thought such pandemic-influenced inflation would only linger for a while, it continues to linger. The Federal Reserve, the U.S. central bank, is now engaged in fighting inflation so that it doesn’t become entrenched. To bring prices down, the Fed has been raising its target interest rate. This has an impact on your variable card interest rates too, which will rise as the Fed targets higher interest rates.
If you pay off your balances at the end of the month, you can avoid the higher interest rate. However, if you do carry a balance, you will pay more in interest on your credit card debt.
Credit card balances outstanding have been going up in 2022, the Fed has reported. They went up 29 percent on an annualized basis in March, about 20 percent in April, and 8 percent in May, making for total outstanding credit card debt of $1.111 trillion as of May.
As the price you pay in interest rises, along with the prices of the goods and services you consume, your real purchasing power will go down. This means that the same amount of money will buy you a reduced level of consumption.
For instance, if the total price of the goods and services you bought last June was $100, in June the same consumption package would have cost you closer to $109 (accounting for the 9 percent rise in inflation). So you are getting less value for your money.
How does inflation impact your credit?
While inflation does not directly impact your credit, there could be fallouts. For one, if you are paying more money to purchase the goods and services you consume, that leaves less money to pay off your debt. Not only that, your credit card balance would go up too.
A higher card balance would impact your utilization ratio, or how much of your available line of credit you are using. This factor accounts for 30 percent of your FICO score. Lenders generally tend to view a lower balance more favorably since they are more assured of getting paid back.
And if you carry a card balance and your variable interest rate goes up, you are also spending more money on servicing that debt. This too leaves you with less money in your pocket.
In case you are hard-pressed to make your card payments and miss a credit card payment as a result, that would have a negative impact on your credit score. Considering that your payment history (your record for making payments on time) accounts for 35 percent of your credit score, missing a payment could be a significant setback to your credit score.
One positive aspect is that you are repaying any debt balances you owe with money that has reduced purchasing power. If the credit card balance you carried last year was $100, for instance, you will be repaying a balance that’s dwindled to $91 this year in real terms, after accounting for inflation.
Tackle your credit card balances strategically
Considering the potential negative consequences for your credit score, you should consider strategically managing your card balances to better deal with the negative impact of inflation. For one, you could transfer the debt to a zero percent rate balance transfer card. While you enjoy the zero percent rate, you would be making inroads into your debt.
You could also consolidate your debt into a personal loan, which will likely offer you a better interest rate than your credit card loan. If you are a homeowner, you could even take out a loan against any equity you have accumulated with home price appreciation. These home equity loans too tend to carry a lower interest rate since they are backed by your home.
The bottom line
Inflation could negatively impact your credit score. For one, as the Fed fights inflation and takes up interest rates, your variable card rates are headed up, along with the prices of other goods and services you pay for. You will be paying more interest on your credit card balance. And as prices go up, you will be using more of your available credit, impacting your credit utilization.
If higher prices, and interest payments, also leave you with less money to make your card payments, you may be at danger of missing a minimum payment, which would take down your credit score. Considering all these negative tangential impacts from inflation on your credit, you should think about managing your credit card debt strategically.