by Thomas J. McFarland, III, CFP®
Interest rates have been at historic lows for some time now. Although no one can definitively predict when they will increase, it is important to know how rising interest rates will impact your portfolio – and how you may be able to plan for it.
Fixed income and equity react differently
When interest rates rise, the market value of a bond portfolio goes down. New bonds are issued at a higher rate of return to compete with elevated market rates. Bonds with a lower yield will be sold at a discount. Holding bonds until maturity avoids the need to sell at a discount. However, depending on the overall market outlook, time until the bonds mature, and other factors, it could be advisable to opt for higher priced bonds that carry a higher return.
Higher interest rates could also affect the equity markets but to a different extent. When interest rates go up, it becomes more expensive to borrow money. Higher interest costs could lower the profits of companies or delay growth. However, the Fed tends to only increase interest rates when the economy is growing, and tries to avoid any drastic measures. Investors and firms have been anticipating a rate increase for some time now, which may help subdue an adverse reaction.
Cost of borrowing
When interest rates go up, it becomes more expensive to borrow money. Whether the higher rates will affect your current loans depends on whether they use a fixed rate or a variable rate. If you have a fixed rate on your car loan or mortgage, the payments stay the same over the entire loan. As a result, the higher Fed rate won’t cause your payments to change.
If you have a variable/adjustable rate on these loans though, the higher Fed rate will cause your monthly payments to go up. Credit cards typically use an adjustable rate so if you have a balance on your cards, expect to pay more per month in interest. Finally, if you want to take out a new loan, the interest rate and the payments on the new loan will be higher if you took out the loan before rates went up.
Better return on your savings
An interest rate increase isn’t completely negative for your finances. Banks will increase the yield on interest-bearing checking and savings accounts. Certificate of Deposit and money market funds will also benefit from the increase. This is especially good news for those in need of a higher return without taking on additional risk. The low rate environment has been especially tough for retirees, who have been struggling to keep up with inflation in cash accounts.
Preparing for an increase in interest rates
There are a couple ways to prepare for increasing interest rates. One way is to reduce market risk in your bond portfolio through a laddering strategy. A bond laddering strategy spreads your investments over different maturities. As interest rates change, the impact on bonds will vary, depending in large part on the maturity. The laddering strategy provides diversification to fluctuating rates. When expecting rates to increase in the near term, short-term bonds will be closer to maturing and investors are able to reinvest at the new, higher rate.
For consumer loans, if you’re thinking about a major purchase or want to refinance a mortgage, you will want to consider making it a priority while you can still apply at the lower, current rates.
Overall, it’s important not to get overwhelmed by the prospect of a rate increase and stay focused on your long-term financial goals and asset allocation. The Fed has given plenty of notice that rates will increase eventually, in hopes of avoiding a measurable adverse reaction.