Navigating an Increasing Interest Rate Environment

We have all felt the pain of inflation over the past year plus, causing the prices of so many of the things we buy to skyrocket. In the wake of the highest level of inflation in decades, the Federal Reserve (the Fed) went into their bag to try and cool down inflation, and in turn the economy, by raising interest rates in general by increasing the Fed Funds Rate, the interest rate that banking institutions lend to each other. Interestingly, to this point, the strategy has been working well to bring inflation down but has not had the kind of negative effect on the economy that many were predicting. While the movement of the Fed Funds Rate does not necessarily directly correlate to the movement of all interest rates, their rate increases tend to have a ripple effect on interest rates more broadly. For instance, the interest rate of a 30-year mortgage has gone from the low 3% range at the start of 2022 to around 7% at the start of August 2023 at the same time that the Fed Funds rate increased from near 0% to 5%. When we hear that interest rates are on the rise, we tend to look at it purely as a negative, but there are two sides to that coin, and depending on what your position is, the rate movement can impact you differently. In this issue of the newsletter, we want to take a broader look at the interest rate environment and how you should consider it as you make your financial moves.

What Increasing Rates Mean for Borrowers
If you need to borrow money, this is where the current rising interest rate environment hurts the most. To be fair, interest rates had been held artificially low for an extended period of time going back to the end of the global financial crisis of 2008, with a shorter period of increased rates from 2016 to 2020. Because rates had been so low for so much time, it would be natural to have a false sense of security with that level of rates, knowing that you could borrow money much more cheaply than under historical conditions. The impact of the increase in rates perhaps has been felt most significantly in the housing market because the jump in rates has priced many people out of buying the home they may have felt was within their reach a couple of years ago. With the length of most mortgages, the impact of a rate increase is felt much more strongly. For example, the difference between a $250,000 30-year mortgage at a 4% rate vs. 7% is about $470 in the monthly payment and almost $170,000 in the amount of interest paid over the life of the loan. That is real money that will impact your ability to choose were you live. On a shorter-term loan, like a car payment, there is an impact, but it is far less significant. Let’s say you are borrowing $25,000 for a car purchase and financing for 5 years. In that case the difference between a 4% and 7% rate is about $35/month and $2,000 over the life of the loan. The important takeaway is that while increases to interest rates are detrimental to borrowing, the amount borrowed and the length of time the borrowing occurs has a much greater impact on how significantly it effects your ability to handle the payment.

The Impact of Rising Rates for Savings
For all of the negatives that go along with increases in interest rates, it does mean that your money being deposited can earn more. During the last 10+ years, bank savings rates have been paltry to say the least, and it could often feel like the amount of interest earned wasn’t even worth counting. As interest rates have gone up over the last 18 months, you have much greater opportunity to accrue a higher level of interest on your deposits than you had for years. However, it is not a given that you will see that occur, depending on where your money is deposited. Most traditional banking institutions have many types of accounts, and there often are accounts where the interest payout may still be extremely low, but that same institution may also have certain accounts that will offer a higher interest rate. In order to qualify for the higher rate, you may have to maintain a certain minimum balance or adhere to some other criteria. If you are open to placing some of your money into an online banking institution, you can often find that those institutions can offer accounts that pay at higher yields than the traditional banks. Another option for increasing your yield is depositing money into a Certificate of Deposit (CD), but in that case, you are committing to leaving your money in that CD for some period of time. In exchange for more limited access, you may be able to achieve a higher level of return.

How Rising Rates Affect the Investment Landscape
If you are investing in fixed income investments (typically bonds), you can see the rise in interest rates directly affect the performance of your investment. For those who are holding fixed income investments directly, if you are planning to keep them until maturity, the rising rate environment has no impact on the interest payout you receive because that is typically locked in at the time of purchase. On the other hand, if you were looking to sell your investment prior to maturity, the increase in interest rates would actually reduce the face value of your investment. Similarly, if you are holding fixed income investments in a managed fund, because the fund manager is likely buying and selling investments in the portfolio on a regular basis, the value of your holdings also could suffer decreases in value as interest rates increase. However, while the value of the investment may dip, the yield may increase as the investment manager buys investments that pay higher interest. The bottom line is that investing in fixed income can be a mixed bag in a rising rate environment, depending on how your investments are positioned. When it comes to investments in stocks, the correlation can be a little harder to predict. Observing business performance over the past decade plus, the relatively low interest rates created a business climate that allowed for more economical borrowing, and many businesses took advantage of that to improve their bottom lines. To this point, the increase in interest rates has not cooled off the stock market, but it is still early in the cycle to know what the impact will be. To some degree, the impact of rising rates on stocks can be a function of the type of business the company is in. The other space that has to be considered with investing is annuities, which are insurance based. Interest rates tend to have a more profound impact on insurance companies, and as a result, for many annuities, a rising interest rate environment can result in more attractive growth potential and improvements to their benefit guarantees.

Despite what you may see in the news headlines about the difficulties the current interest rate environment may cause, the fact is that it is not as simple as saying the rate increase is good or bad. The environment is certainly less favorable for borrowers, but if you are a lender, saver, or investor, the picture may look much different. As with most things, you have to look at your own situation and determine how the state of the current environment may affect you and make wise decisions accordingly. It is for that reason that having a well defined plan is so valuable, so you can have a solid framework for making the decisions that will help you achieve your goals.

Stewardship Emphasis

The impact of a trend change varies depending on what side of the coin you fall on.

The Empowerment Channel |Volume CCXVI | Dedicated to Promoting Financial Education through Stewardship