In recent years, the U.S. economy has experienced an almost unprecedented period of low interest rates. In the immediate aftermath of the financial crisis, the Federal Reserve began an aggressive rate-cutting campaign to try to help jump-start the economy. It quickly brought the effective federal funds rate — the rate at which banks lend money to each other — down from five percent to near zero percent, where it remains today.
A look at the long-term history of interest rates reveals that rates cannot stay this low forever. The question, of course, is when will interest rates start to rise again significantly?
The Economy and Interest Rates
Whenever the U.S. economy shows signs that it might be strengthening — when the employment picture brightens, for example, or the Gross Domestic Product (GDP) number comes in higher than expected — all the pundits start predicting that it won’t be long before the Fed starts raising rates. In addition, the Fed has recently sent out signals that it intends to do just this… eventually.
But recently, bad economic news has been following right on the heels of good news. And when it does, all the talk about rising rates dies down again — until the next ray of economic sunshine peeks through.
As an investor, saver or borrower, all this talk about Fed tightening, quantitative easing (or QE) and the discount rate can get downright confusing and frustrating. You just want to know what should be your financial strategies in the current low-interest rate environment — and what, if anything, you should be doing to prepare for rising rates.
An Interest Rate Primer
Put simply, low interest rates are generally good news for borrowers, but bad news for savers, while high interest rates are generally bad news for borrowers and good news for savers. Whether high or low interest rates are good or bad news for investors depends on the types of investments that they own or are contemplating purchasing.
In general, rising rates are a negative for stocks because they raise the cost of borrowing. That is why the major stock market indices often fall when investors sense that the Fed might be planning to raise rates soon. However, interest rates usually don’t directly affect the price of stocks in the same way that they impact the cost of borrowing or the returns on savings instruments.
Rising rates may also be a negative for bondholders. When rates rise, existing bonds fall in value because they will be paying a lower yield relative to the yield offered by newly issued bonds. However, there are other factors that go into bond investing besides interest rates, such as credit risk, or the risk that the bond might be downgraded or the issuer might default and not repay the principal. Moreover, if bonds aren’t actively traded but are held until maturity, then rising rates have no impact on them.
What Does All This Mean?
Given all of this, here are a few things for borrowers, savers and investors to consider if interest rates start to rise:
- Borrowing will become more expensive. Rising interest rates will increase the cost of all types of borrowing, including home mortgages, consumer loans and credit cards. So if you’re thinking about buying a home or car sometime in the near future, it might be wise to make this purchase sooner rather than later. In addition, if you are carrying high balances on credit cards, it might be wise to start paying down these balances as soon as you can.
- Savings account yields will increase. This is really good news for many individuals who rely on income generated from bank savings and money market accounts and certificates of deposit (CDs) to help meet their monthly living expenses. Many retirees, for example, prefer to invest a high percentage of their assets in relatively safe fixed-income instruments like these.
With interest rates so low, some have had to adjust their lifestyles to accommodate the lower level of income their savings have generated recently. Some others have opted to move some of their assets into riskier investments in order to increase their yield and their income. A rise in rates could enable them to move some assets back into safer fixed-income investments, or resume lifestyle choices they enjoyed before rates dropped.
- The impact on stocks and bonds is less certain. As noted above, rising rates in general are not good news for the stock market. However, there are many factors other than interest rates that affect the price of stocks. As for bonds, rising rates will be a negative for bond traders – as bond values fall when interest rates rise – but will have little if any impact on investors who plan to hold bonds to maturity. The prices of new bonds, meanwhile, will go down, which could benefit bond buyers.
A Crystal Ball?
No one has a crystal ball to see into the future and determine exactly when interest rates will rise and by how much. So the smartest move for most people is try to make wise financial decisions based on what is known right now: that rates are at historic lows and can’t stay this low forever.
Given this, keep the three considerations listed above in mind as you decide the best financial strategies for you and your family when it comes to borrowing, saving and investing.