Dear Carrie: It seems pretty clear that after many years of below-normal levels, interest rates are about to start climbing. What does this mean for my investments and for my finances in general? — A Reader
Dear Reader: Predicting when the Federal Reserve will begin raising interest rates seems to be the top focus of economic forecasters these days. And for good reason. The federal funds rate — the interest rate that banks charge one another to borrow federal funds overnight — has been effectively at zero percent since 2008, so any rate increase would be big news.
Why should the average consumer care what interest rate banks charge one another? Because that same interest rate is used to determine a variety of other short-term rates that touch us all in our daily finances, such as interest on bank deposits, loans, credit cards and adjustable-rate mortgages. And it will ultimately have an effect on both the bond and stock markets.
Overall, the fact that the Fed is considering raising rates is a good thing because it means the economy is doing well. However, a raise in rates would have a different impact on different people. In general, an increase in rates is good for savers and bad for borrowers. For investors, it’s more of a mixed bag, depending on the types of investments you hold.
The current prediction is that the Fed will begin to raise rates this fall or winter. However, it’s also predicted that any rate increase will be slow and gradual rather than dramatic. There’s no need for consumers and individual investors to panic, but it’s a good idea to know what to expect and what changes you may want to make in your own financial strategy.
Impact on Bond Investors
When interest rates rise, bond values decrease. However, the impact will vary depending on your circumstances. Here are three possible scenarios, courtesy of my Schwab colleague Kathy Jones:
–If you’ve been on the sidelines waiting for interest rates to rise, around the time the Fed begins to raise interest rates, you might consider investing in intermediate-term bonds or bond funds that mature in five to 10 years to boost income in your portfolio. You might also consider building a bond ladder by buying individual bonds or bond funds with different maturities. Bond ladders work because they give you the flexibility to make changes as interest rates change.
–If you’re currently invested in long-term bonds, this could be a good time to add some short-term bonds or cash to add balance and reduce volatility.
–If you are already invested in intermediate-term bonds or already have a bond ladder, you may not need to make changes. But again, you could consider adding some short-term bonds or cash to reduce potential volatility as rates change.
Impact on Stock Investors
Generally speaking, interest rate hikes depress stock prices. That also usually means more market ups and downs. The good news is that because of all the speculation on when and by how much rates will rise, it’s most likely already somewhat built in to stock prices. So a rate increase might not have that big of an impact.
As always, keeping a long-term view is important, and diversification is king. But if you are looking to invest, focus on companies that have a strong balance sheet, meaning they have good reserves and less need to borrow. Also, an uptick in interest rates would most likely mean different things for different sectors. For example, financial companies might do well because rising interest rates can increase their margin, or the difference between what they charge for lending and what they pay on deposits.
Impact on All of Us
When it comes to the rest of your financial life, there may be cause to celebrate, as well as areas in which you should proceed with extra caution. If you’re a saver, you can look forward to eventual better returns on your money in savings accounts. Short-term certificate of deposit rates should also begin to go up. That can be especially good news for retirees who have been struggling with very small returns on their cash.
However, borrowers need to beware. If interest rates go up, mortgage rates will rise, which is significant if you’re applying for a new home loan or have a variable-rate mortgage. This could hit first-time buyers especially hard. Consider that a 1 percent interest rate increase can increase the cost of a $100,000 mortgage by over $700 a year. Home equity line of credit rates will start to inch up. Other loans also will be more expensive, so whether you’re financing a car or carrying a balance on your credit card, it’s going to cost more.
Interestingly, rising interest rates might also lead to a decline in home prices (unless you’re in a particularly hot real estate area), so sellers will want to factor that into their plans. And as borrowing costs go up, people tend to buy less, which affects businesses in general.
Keeping a Balanced Perspective
No doubt there’s a lot to be aware of, but it’s also important not to overreact. It’s easy to be swayed by the constant hype and never-ending media speculation, but if you keep on top of your own financial situation, stay diversified and true to your goals, and carefully consider your borrowing needs, you should be able to lessen any negative impact of a rise in interest rates, and perhaps you could turn it to your advantage.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER ™ is president of the Charles Schwab Foundation and author of “It Pays to Talk.” You can e-mail Carrie at askcarrie@schwab.com.