3 important facts you need to know about inflation

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3 important facts you need to know about inflation

From your weekly shop to your energy bills, you may have noticed that there has been a sharp increase in the cost of living in recent months. With the cost of many goods and services rising, you may find that your household finances are being increasingly squeezed. According to data from the Office for National Statistics (ONS), the rate of inflation rose by 7% in the year to March 2022. This is a sizeable rise and one that is more than three times the Bank of England’s (BoE) annual target of 2%. Inflation can have a significant effect on your long-term wealth, so read on to find out three important things you need to know.

1. Inflation erodes the value of your cash over time

During periods of high inflation, the buying power of your money can be eroded if your wealth doesn’t grow as quickly as the increase in prices. You could be particularly at risk if you hold a large portion of your wealth in cash, as low returns mean that it tends to grow very slowly. According to data from Moneyfacts, as of 11 April, the highest interest rate for an easy-access savings account was only 1%. This is significantly below the rate of inflation, meaning that money held in an account like this would lose its real value over time. The best way to see this in action is the BoE’s inflation calculator, which shows the effect of rising prices. In 2021 it would have cost you £1,297 to buy the same goods and services that cost £1,000 in 2011. This is due to an average annual inflation rate of 2.6% over that decade. As we discussed in a previous article, keeping a portion of your wealth in cash to act as an emergency fund can give you greater financial resilience. However, holding too much in this way can be risky for your long-term prospects.

2. Investing your money can help you to protect your wealth

Instead of holding your wealth in cash, investing it can be a good way to protect it against the corrosive effects of inflation. This is because investments typically have greater potential to grow in value, making them more likely to outpace the rising cost of living. Of course, when you invest your wealth it’s important to know how much risk is right for you. While taking too much can sometimes pose a problem, so can being too cautious. Since low-risk investments, such as gilts, typically have a lower rate of return, overreliance on assets like these can mean that your money is still being eroded by inflation. Due to this, your portfolio may not be growing fast enough to reach your financial goals. If you want to be able to invest your money with confidence, working with a financial planner can help you to find the level of risk that’s right for you.

3. Prolonged inflation could lead to higher interest rates

One of the main tools that the BoE uses to control inflation is their base rate, which affects the interest rates that lenders offer. By raising this, it encourages people to spend less and save more, helping to reduce inflation by taking some of the heat out of the economy. In March, the BoE announced that they were raising their base rate to 0.75% and hinted that they may increase it further if necessary. Whether you’re a first-time buyer or have already taken your first step onto the property ladder, this could pose a problem. For a start, banks will factor in higher interest rates when calculating the affordability of their mortgages. According to the Guardian, several UK banks are considering tightening their lending criteria to reflect the rise in rates as well as the squeeze on household finances. If this happened, it could make mortgages more difficult to secure, meaning you may need a larger deposit. As you might imagine, this may affect first-time buyers the most, as they are typically younger and have had less time to build up their wealth. Of course, higher interest rates could also pose a problem for people who are already on the property ladder. If you have a variable- or tracker-rate mortgage, your monthly repayments may become more expensive. For example, if the interest on a £200,000 interest-only mortgage rose from 2% to 3%, you would have to pay an extra £2,000 more each year just to service the loan. If you’re hoping to get onto the property ladder in the near future, during this period of high inflation it’s more important than ever to seek professional advice. When you work with a broker, they can scour the market on your behalf, making it more likely that you’ll find a mortgage that’s right for you.

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If you want to know more about how inflation could affect your progress towards your financial goals, we can help. Email us at office@verve-financial.com or call 0330 320 5048.

Please note:

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.