Find out why the rate of inflation might affect your decision over whether saving or borrowing is the right decision for you.
It’s no secret that the price of goods and services has historically followed an increasing trend, and this rising cost of living is known as inflation.
In the UK, the official measure of inflation is the Consumer Price Index (CPI), which has been used to measure inflation since 1997.
The CPI is recorded by the Office for National Statistics (ONS).
It’s calculated by picking a basket of 700 different goods and services and working out how its price has changed over a given period of time.
The price data is collected from around 120,000 retailers and is designed to reflect people’s buying habits.
This means that, from time to time, items on the list of 700 goods and services will be substituted.
The annual rate of inflation indicates how much higher or lower prices are when compared to the same month in the previous year.
For example, if the annual inflation rate in March is 1%, that means prices are 1% higher than they were in March the previous year; to buy the same amount of goods and services, it would cost you 1% more than it did a year ago.
Savers can suffer during periods of high inflation, particularly if saving rates are low at the same time.
Put simply, if the rate of inflation is higher than the interest rate you receive on your savings (after tax), your money won’t be growing and may even be losing value.
The cost of the goods and services you can buy with your savings will be rising faster than the rate at which your savings are increasing in value due to interest.
Because of this it’s wise to regularly compare savings rates to make sure you’ve put your money away in an account that beats the rate of inflation.
While inflation can be a danger for savers, it can actually mean you get more bang for your buck if you’ve borrowed on a loan or credit card, particularly if you’ve managed to get a competitive rate of interest.
For instance, if you want a brand new car that costs £10,000 and you use a 0% credit card to buy it right away, assuming you pay off the debt before the end of the 0% purchase deal, you’ll have paid £10,000 for the car.
If, on the other hand, you decide to save for a year to buy the car and inflation is at 3%, the same new car might cost you £10,300 in a year’s time.
That’s ok if you’ve managed to find an inflation-beating savings account to save your money in but, if not, you’ll lose out and the car will probably cost you more in real terms.
Of course, in reality borrowing isn’t often at 0% APR, but the effects of inflation mean that, in some cases, you can be better off if you take a loan and buy immediately, rather than saving up.
Remember though that if you bought the new car now, its value would most likely depreciate significantly in a year, while the new car would still be worth £10,300.
What’s more, there’s always a chance of deflation - which means that if you saved for a year the car might cost less and you’d be quids in as you’d also have savings interest.
Although CPI is the official measure of inflation in the UK, there are several other indices that have been used in the past but are now considered defunct for most purposes.
RPI was the official UK measure of inflation before CPI, but the things it includes and the way it’s calculated differs.
As with CPI, RPI measures the cost of a representative sample of goods and services, but one of the main differences is that RPI includes housing costs, such as mortgage interest and council tax.
In 2013, a consultation found that RPI should no longer be used or classed as a national statistic because it does not meet European Union standards.
However, RPI is still calculated, so that there’s a consistent historic record of this method of calculating inflation.
In 2015, the RPI was still being used to calculate private sector pensions and index-linked gilt bonds.
The ONS has also published RPIJ since 2013, which includes the services and goods used for RPI, but is calculated using the CPI’s geometric method rather than the RPI’s arithmetic method.
RPIJ doesn’t meet international standards for calculating inflation, but figures have been backdated to 1998 and published by the ONS.
CPIH was developed in 2013 and is almost identical to CPI, except it includes a measure of owner-occupier housing costs.
It’s published by the ONS alongside CPI to address concerns that the CPI measure of inflation fails to include housing costs.
However, it was downgraded to a non-official statistic in 2014.