How do I use the Consumer Price Index (CPI) to get ahead financially?

Consumer Price Index definition

The consumer price index definition may sound like one of those useless and wobbly bits of information that we can all safely ignore, but the real story is different. It turns out that the consumer price index – the CPI – is very important for your bottom line.

1. The CPI shows how much prices are increasing or decreasing
2. It indicates the buying power for money you’ll receive in the future
3. It helps you decide if an investment is worthy or wasteful

The CPI and inflation

According to the Bureau of Labor Statistics, the CPI is published monthly and “measures the change in prices paid by consumers for goods and services.”

So far, this sounds like pretty dull stuff. But when we talk about money, it gets a lot more interesting.

Let’s say you bought a home for $200,000 in January 2010. You sell the property in February 2018 for $275,000. It might seem as though you have a $75,000 gain before selling expenses and closing costs.

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Actually, though, your real profit is far less.

That $75,000 in our example is a solid cash difference. It’s the difference between what you paid for the property and what you sold it for. However, that $75,000 in cash does not represent an increase in buying power.

According to the government, it takes $224,800 in today’s dollars to buy the same goods and services that $200,000 bought in 2010. On a cash basis, you got $275,000, but cash doesn’t go as far as it once did. The reason cash buys less is that inflation erodes the spending power of money.

Using the government’s CPI calculator, we can also figure the problem in a different way. If you had $174,052.07 in January 2010, it would have the same buying power as $200,000 in February 2018.

Consumer Price Index definition

The CPI shows us the difference between nominal cash values (an amount of money) and real cash values corrected for inflation. Why is this important?

Smith can retire on $5,000 a month this year. This is enough to meet all of Smith’s expenses and even allow him to save money every month. But what about the future? If Smith earns a consistent $5,000, each month, his ability to buy will be reduced because of inflation.

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Inflation hurts Smith because he has a fixed income. Let’s also say that Smith financed his home with a fixed-rate mortgage. Smith’s cost for principal and interest is the same every month for the life of the loan. Now, inflation benefits Smith. Each month he pays his lender with dollars that buy less and less.

The lender knows that inflation is eating away at the buying power of his money. For this reason, lenders try to price mortgages so that the interest level will exceed the inflation rate. In fact, the lender is so concerned about inflation that it will offer a lower initial interest rate if Smith — or you — will finance with an adjustable-rate mortgage (ARM).

Lenders love ARMs because if the inflation rate increases, so too do the interest rate on the mortgage.

Taxes and inflation

Here’s another one. Government tax collectors love inflation. In our example of the home sale, the seller made $75,000 in cash. In the case of an owner-occupant, there would probably be no capital gains tax.

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However, if the owner is an investor, the $75,000 gain will be taxed. For a $75,000 gain, a 15 percent tax means an $11,250 bill from Uncle Sam. For details regarding capital gains taxes, be sure to speak with a tax professional.

Notice that the investor is paying a tax on the full $75,000. The government does not discount the cash gain due to inflation. The investor’s real profit is reduced by both inflation and taxes which must be paid to the government.

How do you beat inflation?

The consumer price index definition raises a question. How do you beat inflation? Currently, inflation in the US is under 2 percent.

One answer is to own real estate. Typical property appreciation rates in the US run between 4 and 5 percent. But of course, this varies wildly with the property location.

Real estate does provide additional tax benefits (and a roof over your head) that other investments do not. So the 4 percent appreciation is often more valuable than it initially appears.

A helpful chart: how inflation changes mortgage rates

Of course, relatively few people buy a home for cash. Real estate profits – and losses – are impacted by leverage. If you buy a $200,000 home with 10 percent down, your actual cash investment is $20,000. If the value of the property goes up 5 percent ($10,000), that’s a 50 percent return on your cash investment.

That is a simplified example because you have mortgage interest to deal with. Offset by what you’d have to pay by renting a home if you didn’t own one. Renting a home puts money in your landlord’s pocket when prices increase, not yours.

So the next time someone tells you that the consumer price index definition is as dull as dust, maybe remind them that big money is at stake. Yours and theirs.