I’ve gotten so used to low interest rates that I’m not sure what to expect when they start to rise. I have both investment and savings accounts plus a mortgage and a little bit of credit card debt. Can you explain why this is happening, and what, if anything, I should do about it?
Thanks for this question that's top of mind for so many people. And it’s no wonder—borrowers and investors have been in an unusually low interest rate environment for more years than they might remember.
By way of background, the Fed has indicated that they will gradually increase the federal funds rate (the rate that banks charge each other for overnight loans, which has effectively been at zero for years) over the coming months with the first hikes occurring this past March and May.
Their goal is straightforward: to control inflation, currently at a 40-year high. The theory is that by raising rates, they cool down the economy by slowing demand for goods and services, which in turn slows down price increases. This works because the fed funds rate also determines a variety of other short-term rates that impact our daily finances; for example, interest on bank deposits, loans, credit cards and adjustable-rate mortgages. And ultimately it will also have an effect on both the bond and stock markets.
I can understand why all of this can be concerning, but overall, the fact that the Fed is raising rates is a positive—not only because it reflects their confidence in the strength of the economy, but also because controlling inflation is essential for the economy’s long-term health.
That said, rising interest rates will have an impact on all of us, so it’s important to understand what it means for your different accounts, loans and investments. Broadly speaking, an increase in rates is good for savers and bad for borrowers. It's more of a mixed bag for investors, depending on the types of investments you hold. Let’s take a look.
Impact on savers
A rise in interest rates is good news for savers, although the impact on short-term savings accounts, CDs and money market accounts will take time. Competitive pressures will eventually encourage financial institutions to offer higher rates, so it will be increasingly important to shop around, re-examine how much you need to have in cash and always be mindful of fees and charges that can reduce your returns—regardless of how much and when rates rise.
Impact on borrowers
Whether you're financing a new car or carrying a balance on your credit card, it may cost you more. If you have a choice between a variable or fixed interest rate loan, it's probably better to lock in low-cost financing sooner rather than later.
Mortgage rates are also on the rise, which is significant if you're applying for a new home loan or have a variable-rate mortgage. Consider that a one percent interest rate increase can increase the cost of a $300,000 mortgage by over $2,000 a year. Interestingly though, rising interest rates may also lead to a deceleration in home prices, so sellers will want to factor that into their plans.
Also keep in mind that the Federal Reserve has a lot more control over short-term rates than long-term rates. And as borrowing costs go up, people tend to buy less, which can shift demand and prices lower. If you think your job or business may be impacted negatively by rising rates, take extra care to look at your balance sheet and emergency funds.
Impact on bond investors
When interest rates rise, bond values decrease. However, the impact will vary depending on your circumstances. Here are three possible scenarios courtesy of my colleague at Schwab, Kathy Jones:
- If you've been on the sidelines waiting for interest rates to rise, you might consider investing in intermediate-term bonds or bond funds that mature in five-to-ten years to boost income in your portfolio. You might also consider building a bond ladder by buying individual bonds or bond funds with different maturities. Bond ladders work because they give you the flexibility to make changes as interest rates change.
- If you're currently invested in long-term bonds, this could be a good time to add some short-term bonds or cash to add balance and reduce volatility.
- If you're already invested in intermediate-term bonds or already have a bond ladder, you may not need to make changes. But again, you could consider adding some short-term bonds or cash to reduce potential volatility as rates change or extending the term or maturity of fixed income holdings as rates rise to lock in higher yields.
Impact on stock investors
Generally speaking, interest rate hikes depress stock prices, which can translate to more market volatility. The good news is that because of all the speculation on when and by how much rates will rise, it’s largely already built into stock prices. Therefore, rate increases may not have that big of an impact.
As always, it’s important to be diversified and to maintain a long-term view. I firmly believe that regardless of increases in interest rates, stocks remain the best way to build long-term wealth. It’s still important to spread out your investments globally in a variety of sizes and types of companies, industries and sectors because interest rate hikes will likely mean different things for different sectors of the market. And it’s difficult to predict how any single company will react.
Keeping a balanced perspective
Granted, this is a lot to consider, but try not to over-react. It's easy to be swayed by the never-ending media speculation and hyperbole, but if you keep on top of your own financial situation, stay diversified and true to your goals, and use extra care when borrowing, you should be able to mitigate any negative impact of a rise in interest rates—and perhaps even turn it to your advantage.
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