How to use inflation rates

Inflation is the change to spending power of one unit of a country's currency as measured by annual percentage adjustments. For example, $100.00 at a rate of 2.75% inflation will be worth $97.25 after one year of inflation. 

Inflation can have large affects on the value of money over time and for this reason financial planning with inflation protection in mind is a vital consideration when saving for retirement or calculating the costs of living and the value of one's savings at a future point in time. This article will illustrate the numerical influence of inflation, and provide tips for incorporating inflation in financial planning.

Inflation and time value of money

Knowing how to use inflation rates when planning finances is a key step in optimizing one's investments, cost management and financial needs over time. There are several ways to use inflation rates and incorporate those rates into financial planning. The first step involves identifying a reasonably accurate inflation rate for long-term financial calculations as only past inflation rates can actually be measured. One way to do this is forecasting inflation using a moving average calculation.

Once an inflation rate is identified, the next step is to find the time period for which inflation will be applied to. For example, 6 months would be a short-term inflation adjusted calculation whereas 25 years would be a long-term calculation. Generally, the impact of inflation will be lower for shorter time periods than longer ones. Thirdly, after finding the inflation rate and time period, a financial value and/or set of cash flows may be incorporated into the calculation so that one has something that is being affected by inflation. The following is an example of an inflation-adjusted calculation.

• Manual inflation calculation method:

Inflation rate: 2.5% Time period: 10 years Current Value: $10,000

Year 1: $10,000 multiplied by 2.5%=$250.00, $10,000-$250.00=$9,750.00

Year 2: $9,750.00 multiplied by 2.5%=$243.75, $9,750.00-$243.75=$9,506.25

Year 3: $9,506.25 multiplied by 2.5%=$237.66, $9,506,.25-$237.66=$9,268.59

This process continues until 10 years of inflation are applied. While the inflation dollar value becomes lower with each passing year, so to does the value of the initial amount of money. Eventually, after 10 years of inflation, what was once worth $10,000.00 becomes $7,763.29 or close to 25% less than the original worth of the money.

Incorporating inflation into financial planning

As the previous section illustrates, inflation can have a dramatic influence on the value of money over a relatively short period of time. Prudent financial planning will take into account the cost of inflation when obtaining savings and investment yields and even cost management. There are several ways to incorporate inflation rates into financial planning. For example, some investments are automatically adjusted for inflation. For investments that aren't obtaining a yield higher than inflation and then adjusting the future value of the money for inflation ideally adjust for inflation. The following is a list of ways to incorporate inflation rates into financial planning.

• Invest in inflation-adjusted securities
• Obtain a yield on savings and investments greater than the cost of inflation
• Talk to a financial adviser about inflation when developing a financial plan
• Adjust long-term expenses and equity such as mortgages for inflation
• Calculate cost of living in retirement with inflation in mind

Calculating and using inflation rates when financial planning doesn't have to be overly complicated but does have the affect of making non-inflation retirement plans look like an illusory value in reality. To calculate inflation a number of methods can be used including the technique above. Additional methods include online inflation calculators that are easy to use. All one needs to do using this method is enter the values accurately and let the computer program do the rest.

Summary

Using inflation rates in financial planning is sometimes overlooked, but is actually quite important as the value of money is significantly affected by inflation over time. Inflation can be thought of as a hidden cost that can greatly lower the value of money saved for retirement. It is quite important to be aware of the concept of inflation and how to incorporate inflation into one's financial planning whether it be long term budgeting, investing, expense management or retirement saving.

Inflation can be calculated in a number of ways such as either manually or via calculator. Inflation adjusted calculations can complicate financial planning but is somewhat a necessary evil to factor in. The key variables when using inflation are time, present value, and inflation rate. Obtaining accurate inflation rates may be difficult for long term financial planning but can be estimated using moving average or average inflation values for one's country of residence.