How does deflation affect your personal debt?

Understanding the way that various external economic factors can change your personal financial situation is vital. It can feel confusing if you don’t have much experience in economics, and some people don’t even understand some of the terms used to describe economic factors.

It is also easy to get a bit lost when it comes to understanding whether something is good or bad. What is deflation and why is it such a problem? It is hard to get your head around the fact that both inflation and deflation can mean bad things for the economy and for your own personal financial situation.

Understanding deflation

Deflation is generally understood to be when prices are dropping. This includes the price of goods and services. While you might think that this is a good thing, it can have some grave effects on the economy. Initially, when prices fall somewhat, it is not the end of the world and consequences might not be huge. Consumers will have a little more buying power and the economic downside is not what it could be if things spiral out of control.

In the same way that a small amount of inflation doesn’t cause an instant problem for society or personal finance, a little deflation may not cause huge problems. However, if there is a sustained spell of deflation or an economic recession, and the economy of a country contracts, then it is possibly very bad news for your own finances and personal debt. People can survive a recession and even thrive afterwards but it isn’t generally a good thing.

Deflation can quickly have a knock-on effect on the value of things you own, and even what you might be paid at your job.

Deflation and personal debt

Deflation is always a bad thing for your personal debt. We can use a very simple example to show how this can happen.

Let’s say you borrow $5,000 to buy a second-hand vehicle. At the time, this might well be the best option that you can take. With this loan, you will also be paying interest and this means you are probably paying much more than $6,000 in order to get the vehicle you want.

If deflation hits, and the value of items changes accordingly, then it won’t be long before the vehicle is worth far less than what you paid for it. It could easily drop to the point where it is worth less than $3,000. This means that you are making payments against an asset that is worth considerably less than the outstanding debt, and that your debt doesn’t make a lot of sense. This is a really unfortunate situation and not something that you can always do a great deal about. This is definitely an argument for not borrowing too much money and ensuring that you borrow within your means.

A car may be viewed as an extreme example as it is something that may lose its value fairly quickly anyway, but this also applies to many other items you have used a loan to buy.

Why deflation has this effect

Why does deflation lead to negatives in the economy? What is the problem with deflation, after all? Well, in theory, it is not always a bad thing in the short term if the value of something drops, but when you think it through, lower prices for both goods and services can create a problem for the business world.

If you have built a viable business but suddenly your items and services are not worth as much, then it is possible that you might have to make some changes – you will experience reduced profit margins as a result, which means less money in your pocket and may even cause things like redundancies.

Unfortunately, from the point of view of a business, there isn’t that much that can be done about deflation, which tends to happen based on external factors. Prolonged periods of deflation or severe deflation in a short space of time can have drastic effects.

In times of deflation, the governments and banking organizations don’t have the same level of control and actions they can take as during a period of inflation. With inflation, interest rates are tweaked to try and encourage saving and discourage people from spending too much or borrowing too much. Governments do not have this power to do the same when it comes to deflation. This means that it is often left to the economy to recover on its own, or with certain stimulus packages to try and bring things back to normal.