Question

Suppose you took out $20,000 in student loans at a fixed Interest rate of 5% from a bank. Assume that after you graduate 6 months, inflation rate rises unexpectedly from 3% to 6% as you are paying back your loans. Does the unexpected rise in the inflation rate benefit you in paying back your student loans? Why? Who is hurt more from this unexpected rise in the inflation rate in this case? The borrower(The Student) or the Lender(The bank)? Why? Please explain

Answer 1

The interest at which the loan was taken was the nominal rate of interest. When inflation comes into the situation we study the real rate of interest, that is, the rate of interest that the borrower pays after allowing for inflation. The relationship between the nominal rate of interest, inflation rate and the real rate of interest can be seen by the Fisher's Equation which tells us the following relationship,

where i = nominal rate of interest

r = real rate of interest and

= inflation rate

Considering the given case, when inflation was at 3%, according to this relationship the student was actually paying a real interest rate of 2% on the loan taken. Now, since the inflation rates have risen to 6%, the real rate of interest falls to (-1%). It means that the student is going to pay much lesser in real terms after considering inflation. Therefore rising inflation rates will benefit the borrower in real terms when the nominal rates are fixed, in turn they are going to hurt the lender or the bank in this case since they are facing a negative real interest rate.