November 5, 2013

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Interesting Developments

The Investment Implications of Rising Interest Rates

Sean P. Lee

November 5, 2013

Interest rates are on the rise, and many Americans are wondering what that means for them. While borrowers could be hurt by higher rates, those who are retired or close to retirement could benefit from them.

But how did we move from record-low interest rates to rising interest rates? It has a lot to do with the Federal Reserve. 

Onward and Upward

As a result of the recession in 2008, the Federal Reserve kept interest rates at historic lows. By lowering interest rates, its goal was to make credit less expensive for households and businesses, improving the economy through a surge in spending. The Fed has also put more money into the banking system by purchasing billions of dollars worth of mortgage-backed securities; it’s now in its third round of this “quantitative easing,” or QE3. This, too, kept interest rates low.

Since the beginning of May, interest rates have risen steadily with an improving economy. Strengthening economic indicators such as employment, inflation and growth are the prerequisite for ending the Fed’s record-low rates and QE3.

In June, Fed Chairman Ben Bernanke suggested that the Fed could begin tapering its bond-buying program as early as September. That announcement caused interest rates to rise due to speculation about the Fed’s actions. But in a surprise move at the conclusion of September’s Federal Open Markets Committee (FOMC), Bernanke announced that the program would continue as is. He said that the economy was not yet strong enough for a change, but emphasized that conditions were improving and that tapering was only postponed, not canceled.

The FOMC will meet in mid-December, at which point tapering could begin. 

Prior to the Fed’s September meeting, rates for 30-year fixed-rate mortgages had reached 4.7 percent, the highest rate since spring 2011. After the Fed’s announcement, interest rates declined. By the end of September, the average rate for a 30-year fixed-rate mortgage was below the 4.5 percent level. Despite this drop, rates are more than a full point higher than they were at the same time last year and have the potential to keep increasing. 

Smart Money

The most basic result of higher rates is that it will become more expensive to borrow money. Even a 1 percent increase in your mortgage rate can mean tens of thousands of dollars more out of your pocket throughout the life of the loan.

Although interest rates are higher than they were a year ago, they are still fairly low compared to rates a few years ago. Average rates in 2008 and 2009 were 6.03 and 5.04, respectively. If you are thinking about making a big purchase like a home or a car, or refinancing your home, locking in at today’s rate could potentially save you money in interest in the future.

One of the most dramatic developments over the last few months has been the effect of interest rates on bonds. Treasury bond rates have jumped: 10-year notes increased from just above 1.5 percent at the end of September 2012 to a little over 2.5 percent at the end of September this year. When interest rates rise, bond values fall, because newer bonds become available at a higher rate.

This fall in bond values has been surprising to many investors who thought of bonds as “safe” investments. With interest rates expected to continue their rise, make sure that your portfolio is properly diversified so that you won’t be at the mercy of decreasing bond values.

The results of higher interest rates aren’t all bad, particularly for investors who are retired or will retire soon. Up until recently, many of these more conservative investors have had to choose between rock-bottom returns on their interest-linked investment dollars or face the volatility of the stock market. Now, interest-linked accounts have seen recent increases in credited rates and are providing conservative investors additional opportunities for their investment dollars.

Fixed annuities are one such example. Many fixed annuities are now crediting accounts at interest above the 2 percent rate of inflation. Unlike those annuities, average rates on five-year CDs are still far too low to keep up with inflation. Remember that if your assets are parked in a savings vehicle that’s earning less than the rate of inflation, you are actually losing money, not saving it.

The knowledge that interest rates could continue to rise in the future is powerful for investors. Use that knowledge to evaluate your portfolio and major financial decisions. By taking an interest in interest rates, consumers at every financial stage of life can make wiser decisions now to help them protect their finances in the future.   

Sean P. Lee, MSFS, is president and founder of SPL Financial, Inc.

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