How will rising interest rates (really) affect you?
After much speculation, the Federal Reserve has said it expects to raise long-term interest rates before the year is out, and the move will have some financial impact on nearly every American. Still, depending on your financial situation, there are advantages and disadvantages to an interest rate hike.
As the Federal Reserve wraps up its latest two-day policy meeting Wednesday, the financial world will be searching for clues about the timing of the long-awaited hike on interest rates. The central bank has said that it expects the first hike before the end of 2015, and many think it could come as soon as the Fed's mid-September meeting.
The timing of the eventual hike is a hot topic among economy-watchers and big borrowers who have grown accustomed to years of cheap money. But the rest of us start to snooze when we hear pundits on TV droning away about “interest rates” in an economic policy context, as we have for the past year and a half or so.
The Fed's decision, however, affects anyone who has a home mortgage, a car loan, a savings account, or money invested in the stock market. In reality, that’s almost everyone in America. In fact, experts say, the impact is so far reaching that even unemployed recent graduates living at home with their parents will feel it. So unless you live completely off the grid, it’s probably a good time to take notice.
“If you’re living on cash, and your job is secure, it doesn’t affect you,but there are very few people who literally have no net savings put away or are not borrowing." says Douglas Holtz-Eakin, president of the American Action Forum and former chief economist of the President’s Council of Economic Advisers. "People use credit cards, all sorts of loans to make purchases, and so the impact will be pretty largely felt."
What are interest rates and why do they change?
Generally speaking, an interest rate is the additional percentage of a loan that the borrower is charged until the payment is completed, usually an annual percentage of the outstanding loan. The Federal Reserve's policy rate has been kept at or near zero for the past seven and a half years, making it very easy to borrow.
Despite the fear that rising interest rates could stymie growth, a decision to support a rate hike is generally a sign that the economy is doing well. In the face of expanding GDP and falling unemployment, interest rates that are too low could create excess demand by making it a little too easy to make big purchases. The more people feel free to buy, the more others can charge for what’s being purchased, potentially leading to inflation and an overheated economy. That’s why the Fed raises its rates as the economy improves; the intent is to slow inflation by keeping supply and demand balanced.
Deciding exactly when to raise interest rates can be a tricky business due to the risk of slowing down an economy that still has weaknesses, including slow wage growth and timid spending among consumers.
What are the drawbacks of a rate hike?
Raising interest rates can make it more expensive for people to borrow money to pay for things such as homes and cars. As interest rates rise, demand for the things people tend to pay for with loans tends to drop. Higher interest rates can also make it more expensive for companies to borrow and invest large sums of money in projects.
“When interest rates go up, some people will notice almost immediately as banks adjust the interest rates they offer consumers," says Kimberly Palmer, Senior Editor of Money for US News and World Report, and author of the book ‘The Economy of You’. "Anyone looking to take out a mortgage or an auto loan, for example, will find rates higher and their loans more expensive."
If the market is doing well and plenty of cash is flowing, demand probably won’t drop enough to seriously harm the economy, experts say.
Nevertheless, for people with financial assets such as bonds, the price of their assets could fall due to rising interest rates. That’s because bonds typically pay their owner a fixed (or unchangeable) interest rate until it reaches maturity (the finite period of time when a financial instrument, like a bond, ceases to exist and the original cost is repaid with interest). That means that if interest rates rise, the bond’s value falls because its yields, or returns on investment, are still pegged to the previous, lower interest rate. People who have a lot of their assets invested in bonds will be carefully watching how high the interest rates rise because the value of their bonds drops commensurate with how high the interest rate goes.
What are the benefits?
At least one group should be celebrating a potential rate hike: savers. Since interest rates fell during the financial crisis, people who have money stashed in savings accounts have earned almost nothing from the interest on their deposits. As the costs of funds goes up due to rising interest rates, banks will pay more for customers’ money as they begin competing to get it. Moreover, for retirees and others who earn a substantial portion of their income from interest on their savings, life is about to get a lot easier.
“Think about all of those people who retired 10 years ago. They had a 10 year portfolio, or 10 year CD [Certificates of Deposit], and they were earning a certain amount until those CDs matured. They were living off of that income, and when the CDs matured they went to reinvest them and their income was literally cut in half, or maybe to even a quarter of what they had,” explains Carl Richards, a financial planner and author of the book "The One-Page Financial Plan."
“That’s so painful to think about because they made good decisions, they were smart, they invested safely, and now they are dealing with 50 percent or 25 percent of the income they used to have,” he concludes.
Now, as their CDs and other fixed financial instruments mature, those retirees can buy new ones at higher interest rates and earn a lot more money. That's great news for many of the estimated 10,000 baby boomers heading toward retirement each day.
Tim Maurer, Director of personal finance at BAM Advisor Services, agrees that rising interest rates will benefit a lot of people.
“Savers have been punished for over a decade in the United States, while borrowers have been rewarded because we all hope that stimulates the economy," he says. "Savers have been punished long enough and I’m rooting for them to make more money on their fixed income vehicles."
Could it impact housing?
While there is no direct correlation between the short term interest rates controlled by the Fed and mortgage costs, most analysts believe that rising interest rates ultimately lead to higher mortgage rates, which means aspiring homeowners should expect to pay more over the course of their mortgage. That could price some people out of the market. Moreover, interest rate movement also impacts the rental market, so even people without a mortgage will notice the change.
“If you’re just sort of getting your feet underneath you from 2008-2009, and you’re thinking, ‘ok, I can afford to buy a house now’, then rates move up a percent, a percent and a half, or two percent, which would be sort of normal, you’ve suddenly been completely priced out of the neighborhood you thought you could purchase in, or perhaps the neighborhood you’re renting in,” says Mr. Richards.
For Americans who have an adjustable rate mortgage on their homes news of a rising interest rate also probably isn’t very welcome. Luckily, there aren't too many of those. According to data from the Urban Institute, in June 2015 89.4 percent of mortgages were 30-year fixed rate mortgages, while 5.0 percent of them were 15-year fixed rate mortgages.
Adjustable rates are now harder to come by thanks to stricter lending standards in the wake of the housing crash; they account for just 4.5 percent of the market, down from 29 percent at the height of the 2005 housing bubble. Furthermore, low interest rates of the past seven years have allowed most mortgage holders to lock in a fixed-rate mortgage at a rate almost as low as that of a typical adjustable mortgage.
Even for the sliver of homewners who still have an adjustable rate, the future may not be so bleak. Adjustable mortgages are generally pegged to the 10-year Treasury bill. Treasury bill yields are often pretty low due to high demand from investors, both in the US and overseas, who are looking for a safe place to put their money. The Treasury bill’s low yield means that even adjustable mortgage rates could rise rather slowly even after the Fed hike happens.
Meanwhile, although some postulate that rising mortgage rates could cause a slump in demand for housing, many experts assert that the decision to take out a mortgage is influenced more by life events than by interest rates.
“The truth is home ownership isn’t driven by interest rates. It has an influence, especially in regards to refinancing," says Maurer. "And certainly when rates go lower people are able to refinance and they end up paying less for same amount of house, they can use the additional money to better themselves, to pay down debt, to invest, or to spend, which should bolster the economy. But home ownership is driven by life events, not on interest rates. People move, or they get a new job, they get a raise, they get married, they have children.”
That being the case, many experts say it’s unlikely the housing market will face major setbacks due to a rate hike.
What you can do
The good news is that people can plan for a rate hike and make smart financial decisions. Many financial planners suggest the concept of laddering ̶ or creating a portfolio of fixed income securities, or an investment that pays fixed periodic payments during its existence, where the maturity date of each security is different.
“To insulate yourself from these sorts of things…you lock in your mortgage interest rate for as short of a term as you can while still affording a payment," explains Richards. "So if you can afford a 15-year rate, awesome. If not, you can lock in your 30 year rate. Then your bond portfolio is laddered, so CDs mature, some portion of your portfolio matures every year, you get the opportunity to reinvest it at a rising interest rate. If your portfolio is designed well to deal with the reality that interest rates change, which shouldn’t be a surprise to anyone, there is a way to manage risk.”
Financial advisors also suggest that investors shy away from taking too many risks while the interest rates are low, such as buying junk bonds with potentially higher yields instead of insured government bonds with lower interest rates.
“The concept of laddering in your fixed income portfolio makes a lot of sense,” confirms Maurer. “First and foremost, do not take undue risk born of impatience with low interest rates, don’t shift money that you know should probably be in the fixed income portion of your portfolio to the stock portion because you’re sick of low interest rates. Don’t go from US treasury to junk bonds because you’re sick of low interest rates.”
Meanwhile, some suggest that if you know you’re going to buy something with credit in the near future, you probably shouldn’t wait.
“Looking forward, the best guess is rates can only go up, not down,” says Dr. Holtz-Eakin. “That means if you’re looking to buy something now or later using credit, buy it now because the rates will be low.”
And if feasible, putting away savings each month is never a bad idea.
“Continue saving as much as possible to take advantage of those rates and be a savvy shopper with any new loans – shop around and compare rates so you can get the lowest one available,” Ms. Palmer suggests.