With the Federal Reserve phasing out the loose monetary policy it adopted in response to the financial crisis, you may be wondering how you could be affected should interest rates climb back to historically normal levels. That will depend partly on your life stage.
One way the Fed manages interest rates is by setting a target rate for the amount of interest banks charge each other for overnight loans. When this rate changes, the effects can touch everything from short-term Treasuries to 30-year mortgage rates. Here’s how rising rates may affect investors in three demographic groups:
Recent grads/starting out (20s and 30s)
In general, young adults commit more of their financial energy to borrowing and consuming than to long-term investing. This is a time when many are paying down college loan debt (or possibly taking out new loans for graduate school), or buying a car or first home.
- Student loan debt. Interest rates on federal student loans are set by Congress. However, in the private market, student loan rates tend to be based on the three-month London Interbank Offered Rate, which is highly correlated to the federal funds rate. Refinancing an existing student loan, or taking out a new loan, may become more costly once the Fed begins raising rates.
- Retirement accounts. With retirement still far away, younger people typically hold a smaller portion of their assets in fixed income securities compared with older investors. As a result, their retirement accounts should be less exposed to the negative effect rising rates can have on fixed income security prices.
- Savings rates. Savings account holders have been earning extremely low interest rates—often near zero—during the past six-plus years, compared with annual yields of 4% or more in the years leading up to the 2007–08 financial crisis. Once the Fed begins to raise short-term rates, the rates paid on savings accounts should begin to rise, as well.
- Mortgage loans. Mortgage rates can be a key factor in how much a potential homebuyer is able to afford. However, mortgage rates generally track long-term bond yields, which are more affected by expectations for long-term economic growth and inflation than by the short-term federal funds rate. While an increase in the federal funds rate is unlikely to cause 30-year mortgage rates to zoom higher, once the Fed begins to raise short-term rates it’s far more likely that mortgage rates will rise than fall. In particular, adjustable-rate mortgages (ARMs), which have a fixed interest rate for an initial term and then shift along with changes in interest rates thereafter, could see higher reset rates. Overall, if you’re just starting out, there’s probably no need to worry about buying a home in the next few months versus within the next few years. And those who do make a purchase may want to consider locking in a rate with a 30-year fixed-rate mortgage.
- Auto loans. The interest rate on variable-rate auto loans is generally tied to the U.S. prime lending rate, which is highly correlated to the federal funds rate. Even fixed-rate auto loans tend to be driven by short-term rates, although rates can vary depending on sales incentives and other factors. Financing a car purchase could become more expensive as the Fed raises rates.
- Consumer debt. Eventually, a higher federal funds rate will affect all forms of consumer debt, including credit card debt. Such debt will also likely grow more costly at a faster rate than other types of debt.
Mid-career/family (40s and 50s)
Compared with younger investors, people in their 40s and 50s usually have more in the way of assets—and debt—that could be affected.
- Mortgage refinancing. Given that 30-year fixed-rate mortgage rates have been historically low for years—they averaged 3.8% during the first eight months of 2015, compared with 6.4% in full-year 2006, 8% in 2000, and 10% in 19901—homeowners whose current mortgage rate is higher than the market rate may want to think about refinancing. If you have an ARM, you may want to consider refinancing at a fixed rate.
- HELOCs. Rates on a home equity line of credit (HELOC)—a loan in which the collateral is the borrower’s equity in his or her house—are generally variable and tied to the prime rate, the interest rate that banks charge their most creditworthy customers. This means a higher federal funds rate could lead to higher HELOC rates. Again, if possible, consider refinancing at a fixed rate.
- Retirement accounts. Investors in their 40s and 50s are likely to have a greater proportion of fixed income or dividend-paying investments than younger investors, and these can be negatively affected by a Fed rate hike. Stocks have typically performed well ahead of a rate increase and during the first year afterward, but not all equity sectors perform the same way. Dividend-paying stocks, such as those in the utilities sector, may underperform; these stocks are often purchased for their higher yields, but as bond yields move higher, dividend-paying stocks can become relatively less attractive.
Nearing retirement/In retirement (60s and 70s)
A higher federal funds rate may have the greatest impact on people who are close to or currently in retirement, as they tend to have the greatest proportion of financial assets allocated to fixed income products. But a higher federal funds rate can affect fixed income investments differently.
- Cash and cash equivalents. Investors in cash-equivalent vehicles, such as savings accounts, money-market accounts, or short-term certificates of deposit (CDs), should benefit as interest rates on these accounts can be expected to rise (CDs pay a fixed rate, but as they mature the proceeds can be rolled into new, higher-yielding CDs).
- Short-term bonds—generally, those with maturities of around two years or less—are highly correlated with the federal funds rate. Prices of short-term bonds may initially fall as rates rise because bond prices and yields move in opposite directions. However, short-term bond investors might also be well placed to benefit from higher interest rates because they can roll their maturing short-term bonds into newer bonds offering higher yields. Those investors sitting on the sidelines waiting for higher short-term yields may finally be rewarded, but Schwab would caution that rates all across the yield curve could remain well below historical norms for the next few years, or even longer.
- Intermediate-term bonds—generally, those with maturities ranging from around five years to 10 years—may also see some price swings after a rate hike, but their sensitivity could vary depending on the maturity. We would recommend focusing on maturities falling somewhere in the middle of the range: greater than five years and less than 10 years. But make sure you have a long enough time horizon to be able to deal with any drop in price.
- Long-term bond yields won’t necessarily rise when the Fed raises its benchmark interest rate, as long-term yields are affected more by growth and inflation expectations than by short-term rates. However, because their maturity dates are so far away, any given interest rate change will have the greatest effect on long-term bond prices. Be sure your investing time horizon is appropriate when investing in long-term bonds.
1The Freddie Mac Primary Mortgage Market Survey®. The survey is based on first-lien prime conventional conforming home purchase mortgages with a loan-to-value of 80 percent. Data as of 9/24/2015.
What can you do?
Obviously, every individual investor’s case will be different. Higher rates will mean different things to different investors, depending on their age as well as their financial situation. But there are a few things you can review to get a better sense of where you stand:
- Interest-bearing accounts
- Retirement accounts
- Bond portfolio
If you have questions, talk with a Schwab Consultant.