Understanding Inflation and Its Effect on Your Money
Inflation is the general rise in prices over time. When inflation is 6% a year, something that costs 100 today will cost about 106 next year. It feels small year to year, but over a decade or two it changes what your money can buy dramatically.
Two ways to look at inflation
Future cost
How much will something that costs a certain amount today cost in future? The formula is Future cost = Today's cost × (1 + inflation)years. This helps with goals like school fees, a wedding or retirement expenses that are years away.
Purchasing power
How much will a sum of money be worth in today's terms if it just sits still? The formula is Real value = Amount ÷ (1 + inflation)years. Cash kept under the mattress, or in an account paying less than inflation, quietly loses value.
Why this matters for your finances
- Savings goals should be set in future prices, not today's.
- Investments need to beat inflation to actually grow your wealth. A return of 5% with 6% inflation is a loss in real terms.
- Salaries that don't keep up with inflation mean a falling standard of living.
- Fixed-rate loans become easier to repay over time, because your EMI stays the same while incomes generally rise.
Choosing an inflation rate
Official inflation figures vary by country and change from year to year. For long-term planning, many people use a long-run average rather than the latest number. Keep in mind that some costs, such as education and healthcare, often rise faster than general inflation.