Inflation is the effect of rising prices on your buying power. Inflation is often left out of the equation when calculating how much money you’ll have available at some point down the road, but it can make serious inroads into the buying power of your money. In the United States, the average annual inflation rate since 1990 has been approximately 2.5 percent. Since 1990, the price of goods and services has increased 106 percent, so an item that cost $100 in 1990 costs $206 in 2020. Since much of financial planning is done for years into the future, it’s important to consider the impact of inflation when determining how much money you’ll need in retirement, for example.
The Effects of Inflation
The $30,000 salary you earn this year will be worth only $28,800 in purchasing power next year if inflation is 4 percent. If you’re fortunate, you’ll get a salary increase annually that at least keeps pace with the rate of inflation; otherwise you fall further behind each year.
You can use the rule of 72 to estimate the real buying power of a sum of money at some point in the future, taking inflation into consideration. If the inflation rate is 4 percent, prices will double in eighteen years (72 ÷ 4 = 18), so if you plan to retire in eighteen years and you need $3,000 a month in today’s money, you’d need $6,000 a month to retain the same buying power you have today.
The time value of money is a basic financial concept based on the assumption that a dollar received today is worth more than a dollar received at some future date because today’s dollar can be invested and earn interest. If someone offered to pay you either $1,000 ten years from now or some lesser amount today, you could calculate the amount you’d need to receive today to equal or exceed the value of $1,000 in ten years and decide which is the better deal. You do this by backing into the amount using current interest rates. For example, if the current interest rate is 3 percent, you might be willing to accept $744 today rather than waiting ten years for your $1,000 because you’re confident interest rates will stay level or increase over the next ten years.