The Cost of Borrowing & Inflation

Entrepreneurs face a variety of financial hurdles when starting businesses, from coming up with funds necessary to launch new ventures to making sure they have enough cash on hand to cover immediate expenses. Small businesses may turn to loans and credit lines to secure the financing they need, but taking on debt can be expensive. The cost of borrowing depends, in part, on the rate at which prices in the economy are increasing.

When an individual or business takes out a loan or racks up a balance on a credit account, the lender charges interest on the balance. Interest is basically a fee paid for the privilege of using someone else's money and is assessed as a percentage of the amount borrowed. For instance, a $10,000 loan with a 5 percent annual interest rate requires the borrower to pay $500 in interest for the year. Debts can also require the payment of fees that increase total cost beyond the basic interest rate.

The cost of goods and services in the economy tend to increase gradually, which is a phenomenon called inflation. Inflation causes the purchasing power of currency to decline: When prices are rising, a dollar buys more today than it does tomorrow. Inflation makes it costly to keep a lot of cash on hand, as it causes the value of that cash to erode over time. Putting cash to work by saving it in an interest-bearing account or investing it can mitigate the negative effects of inflation.

Although inflation is bad for those with cash on hand, it can be a good thing for borrowers. When a business borrows money, it gets cash it can use now that it can pay back later. Since inflation causes the value of currency to decline over time, cash now is worth more than cash in the future. In other words, inflation lets debtors pay lenders back with money that is worth less than it was when they originally borrowed it.

Because inflation reduces the true cost of borrowing, the interest rates lenders charge don't tell the whole story. Economists sometimes use "real" interest rates to account for the effects of inflation: A real interest rate is the stated or nominal interest rate minus the inflation rate. For example, if a business takes out a loan with a 5 percent annual interest rate but the inflation rate is 3 percent, the real interest rate is only 2 percent.