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Rising interest rates: What they mean for you and how to prepare
Edelman Financial Engines
March 25, 2022
We all know that consumer prices have been moving higher (also known as
inflation). As our nation’s central bank, the Federal Reserve is expected to
raise interest rates this year. Why? Because making it more expensive to borrow
money can slow down the amount of spending that’s pushing prices higher. (On the
other hand, when the economy isn’t growing, they’ll cut interest rates to
stimulate spending again, as they did after Covid-19 hit.) Analysts expect there
could be at least three rate increases this year, with the first hike of 0.25%
announced at March’s Fed meeting.1
How could the Fed interest rate hikes affect you? That can depend on whether you
are an investor, a borrower, a lender or a consumer – higher interest rates can
have a range of effects. Overall, though, higher interest rates can work in your
favor – if you have a plan in place.
QUICK TAKE:
* Savers may see a better return on cash savings.
* Borrowers could face higher interest rates on debt.
* Some investments may perform better than others in a rising rate environment
– that’s why you should consider having a retirement portfolio that is
diversified with different types of investments.
SOME BACKGROUND ON FED INTEREST RATE HIKES
Since the Covid-19 crisis began, the Fed has kept its benchmark interest rate
exceptionally low – in fact, close to zero. The last (and only other) time the
Fed kept interest rates so low was in response to the global financial crisis of
2007-2009. That’s why this gradual return to “business as usual” really comes as
no surprise.
BORROWERS BEWARE, SAVERS REJOICE
Anyone borrowing money this year – whether it is an individual applying for a
credit card or a corporation taking out a significant loan – may end up paying a
higher rate on the borrowed amount.
On the other hand, income-starved savers stand to see better yields – whether
those are in savings or checking accounts, certificates of deposit or money
market accounts. Savings or money market accounts, according to the FDIC, offer
savers only 0.06% or 0.08% in interest, respectively, while a 12-month CD yields
just 0.15%.2 So, despite the risk that higher inflation poses to savings, higher
rates will be welcome news.
WHAT DO HIGHER RATES MEAN FOR INVESTMENTS?
Higher interest rates can have a range of effects on investment markets. For
example, rumors of Fed actions can affect the behavior of markets. You may
remember that in January 2022, uncertainty about how aggressive the Fed might be
led to a volatile month for markets. But this is a short-term, psychological
effect – where traders try to account for future Fed moves.
In the longer term, though, higher rates can affect stocks and bonds in more
lasting ways. For example, some companies may find it more expensive to do
business – so their future growth may slow down, which can impact the stock
price. Other companies – like banks – may benefit from higher rates.
The bond market is historically even more sensitive to interest rate increases.
Why? Bonds are issued with a certain rate attached – it is a promise to repay
the purchaser after a certain amount of time, at that rate.
So, when interest rates are rising, the rate offered by a bond may suddenly seem
less appealing when there will soon be new bonds on the market that offer a
higher rate. That is why bond prices tend to drop when the Fed announces rate
hikes – especially for short- or medium-term bonds.
Overall, different types of investments react in different ways to changes in
interest rates. That is why you should consider having your retirement account
employ a diversified investment strategy that includes different kinds of
investments. You may have heard the expression, “Don’t put all your eggs in one
basket” – the same thing applies to investments. You do not want to have too
much of your retirement account concentrated in just one area of the market –
that’s why having a diversified portfolio is important.
HOW TO PREPARE FOR HIGHER RATES
Rising interest rates won’t affect every aspect of your financial life in the
same way. But there are a few steps you can take now to help make sure you are
positioned for any benefit:
Build up your cash. If you do not have the recommended amount of cash reserves
on hand (three to 24 months of expenses, depending on your situation), now is
the time to take advantage of any higher rates that may be offered this year and
save more money if you can.
Pay down high-interest debt. Especially if you have variable-rate loans or
credit card debt, try to reduce the outstanding amount before the increases kick
in. Lock in low rates on loans and refinance mortgages whenever possible.
Keep your retirement account invested. The diversified mix of investments in
your portfolio should seek to deliver returns over time that are higher than the
inflation rate. So stay focused and don’t tap into your future wealth to get
through this.
1 Board of Governors of the Federal Reserve System. (2022, March 16). Federal
Reserve issues FOMC statement.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20220316a.htm
2 Federal Deposit Insurance Corporation. (2022, February 22). National Rates and
Rate Caps. https://www.fdic.gov/resources/bankers/national-rates/index.html
Investing strategies, such as asset allocation, diversification or rebalancing,
do not assure or guarantee better performance and cannot eliminate the risk of
investment losses. All investments have inherent risks, including loss of
principal. There are no guarantees that a portfolio employing these or any other
strategy will outperform a portfolio that does not engage in such strategies.
Past performance does not guarantee future results.
AM 2090350
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October 5, 2021
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