Glossary
Inflation is the rate at which the price of goods increases over time. It's what causes $1 today to be worth much less than $1 in 1950.
Why does this matter to us? When we think about investing and debt, we need to consider that our money will be worth less in the future than it is today. Generally, we "account for inflation" when thinking about the future value of an asset.
Say we deposit $1,000 into a savings account with a 2% interest rate.
| |
Today's Value | |
Savings Interest Rate | or |
Inflation Rate | or |
Years | |
Future Value (in future dollars) | |
Future Value (in today's dollars) | |
In 10 years, we will have earned 2% of our money every year and we'll have $1,219 in our savings account. However, once considering the inflation rate, we'll actually be able to buy less than what we could have had we spent the money today, simply because things in the future will be more expensive than they are today. In other words, that $1,219 will have the same buying power in 10 years as $904 does today.
It's very important to consider inflation when considering investments and debt. Historically in the US, annual inflation has averaged about 3%. In general, investing in things with expected returns higher than 3% and securing a mortgage (or other strategic loan) with interest rates lower than 3% will make you richer than just letting your money sit.
