# The Effect of Deflation on Debt

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Deflation is a relatively simple thing It refers to falling prices. While this might sound like a good thing, it really isn't. One of the biggest problems with it is that it effectively increases the cost of your debts. Since deflation is also damaging to the economy as a whole, it can also increase the risk that you won't be able to pay your debts.

## Understanding Deflation

At first glance, deflation sounds like a good thing. It's nice when prices drop. However, there's a difference between isolated price drops for certain items and economy-wide deflation. When prices drop on a certain item, like gasoline or computers, consumers reap the benefit and are able to spend more money on other things. When prices drop on everything, consumers and businesses start to pull back on spending, waiting for even lower prices. This reduction in economic activity can cause a recession or a depression.

## How Debt Works

When someone lends you money, he assumes that you'll be paying him back in the future with money that's worth less than today. That's why he charges you interest. Some of it compensates him for letting you use his money and the rest of it helps to insure him against inflation. After all, if the inflation rate is 3 percent per year and he doesn't get at least 3 percent, he'll lose money.

## Deflation and Interest Rates

Deflation has one short-term benefit: It can decrease interest rates. If lenders know that they'll be paid back with money more valuable than the money they lend, they can charge less interest and end up better off. If you have debts at variable interest rates, you might benefit a little bit from deflation.

## Deflation and Debt Cost

Even if the interest rate on your debt goes down, the effective cost of the debt goes up. Since the dollar buys more in deflationary times but your debt payment stays the same, you're actually paying more. For example, imagine a \$1,000 mortgage payment. You could spend the \$1,000 to pay your mortgage, or you could buy 300 gallons of gas with it. If deflation hits and gas goes down to \$2.00 per gallon, you'd be giving the bank 500 gallons of gas worth of money, effectively increasing the cost of that payment.