We’ve been living in a kind of fantasy land because we’ve grown accustomed to low-interest rates. We all know the story: As the economy tanked and stocks plummeted, the Federal Reserve pulled out all the stops, including a massive asset-buying binge and cutting benchmark interest rates down to zero.
While the move was designed to be temporary, this zero interest-rate policy (ZIRP) managed to stick around for a multitude of years. In this environment, we’ve forgotten how to act when things return to a more normalized rate scenario. And we’re not talking just about our portfolios. There are a lot of other personal finance items that are affected by higher rates. With the Fed finally starting to raise them, now is not the time to ignore them.
Take a look at our guide to higher rates.
Yellen, We Have Lift-Off
With the economy starting to move in a positive direction and inflation heating up, investors have been forced to deal with an old foe: rising rates. After nearly a decade of zero rate increases, Janet Yellen and the Federal Reserve have raised rates three times since December of 2015.
And more could be on the horizon. Unless the economy suddenly takes a turn for the worse, analysts expect the Fed to raise rates a total of three more times this year. Over the next few years, the central bank estimates that it’ll return to a more normalized rate range of around 2.75% to 3.25%.
These higher rates have plenty of implications for investors. Most of the advice on the web these days focuses on what to do with your portfolio as the Fed raises: sell long-term bonds, avoid this sector, buy these sorts of stocks, etc. – and that advice is valuable. After all, we’ve spent a decade with ZIRP. Many of us have forgotten exactly what happens to a bond fund like iShares 20+ Year Treasury Bond ETF (TLT) during a period of rising interest rates.
But there is another side to rising interest rates that bears mentioning, and that’s debt.
The problem is that much of our debt is directly tied to what the Federal Reserve does, especially when it comes to credit cards. Interest rates charged on a credit card are based on the prime rate, which, in turn, relies on the Federal Funds rate. As a result, when the Fed hikes rates, the cost of borrowing money via a credit card goes up. According to credit website WalletHub, the recent quarter-percentage-point increase to interest rates will tack on an extra $1.6 billion in additional finance charges this year for consumers. Ouch.
Rising rates are also a problem for those consumers with adjustable rate mortgages. For example, the quarter-percentage-point increase will add an additional $1,250 in interest on a $500,000 home loan in the first year of the ARM reset.
Do This Right Now
While tweaking your portfolio amid the recent increases in interest rates is certainly warranted, if you’re like most Americans, taking a hard look at your debt is also needed. The typical American family carries around $16,000 in credit card balances.
With rates rising, it’s safe to say that paying down any balances on credit cards needs to be a top priority. In the end, if the Fed raises and then keeps on raising rates, those high balances are going to become a real problem and cost you even more to dig yourself out. Make a plan to pay them off now while the Fed still hasn’t ratcheted up things too much.
Secondly, if you have an adjustable rate mortgage, now is the time to consider refinancing to a fixed one. By doing so, you’ll be able to lock in a lower rate for a longer period and avoid the nasty pitfalls of subsequently higher and higher interest payments.
In the end, debt management is an absolutely paramount thing to do while the Fed starts to normalize interest rates.
The Bottom Line
While most of us think about the Fed’s decision to raise rates only impacting our portfolios, the truth is that it impacts our borrowing costs as well. For those carrying higher debt burdens, the need to reduce your balance is great. Higher rates will only cost you more money down the road.
Redistributed from Dividend.Com