As the Federal Reserve raises interest rates to fight inflation and prevent the economy from overheating, the effects are felt throughout the economy and household finances. Many things that result can negatively impact your finances if you don’t prepare properly in advance or react quickly to eliminate any potential impact. Working with a financial advisor can help you prepare an appropriate financial plan and action plan.
What happens when interest rates rise
Rising interest rates impact your finances in several ways. Some are positive, while others are negative. Knowing what is likely to happen will give you a head start in preparing your finances to deal with potential rate increases. Here are the six things that typically happen when interest rates rise:
1. The cost of borrowing increases
As interest rates rise, it becomes more expensive to borrow money. Interest rates are one of the three main factors that determine your monthly payment. The others are the amount borrowed and the repayment time of the debt.
Borrowers with variable interest rate debt are immediately affected by the rate increase. Existing fixed rate loans are not affected, but repayments of new loans may increase significantly.
For example, if you want to borrow $300,000 over 30 years, the payment can increase significantly as interest rates rise. At 2% interest, your monthly payment is $1,108.86. However, when the rates increase to 4%, the payment increases to $1,432.25 per month, almost 30% more.
2. Consumer demand declines
When it costs more to borrow, consumers tend to reduce their spending. Unless their income also increases, rising interest rates reduce their disposable income. Because they pay more for their purchases, they have less money available to purchase other items. This “cooling” of consumer spending is the goal of the Federal Reserve when raising rates.
3. Savers earn more interest
People who have money in savings accounts, money market accounts and CDs benefit from rising interest rates. Banks are raising the rates they pay to attract new customers and retain deposits from existing customers.
Savings accounts and money market accounts generally increase within a month of the Federal Reserve rate increase. However, the prices of your CD are fixed until its maturity. New CD rates vary based on market rates, the term of the CD, and the bank’s funding needs.
4. Stocks are becoming less attractive
When investors can earn higher interest on bank deposits and bonds, stocks become less attractive. Essentially, investors don’t have to accept as much risk to generate the same returns on their money. For this reason, some investors sell certain positions and reallocate that money into CDs, bonds, and money market accounts.
5. Decrease in the value of bonds
Higher interest rates reduce the value of existing bonds. When an investor can receive a higher yield on a newly issued bond, there is less demand for existing bonds with lower rates.
On the positive side, although the current price is lower, if you hold your bond until maturity, you will receive the full face value. This is not the case with bond mutual funds and ETFs. They reprice daily based on the value of the bonds in the portfolio and rarely hold bonds to maturity.
6. Buying a house is more expensive
Household budgets and underwriting limits limit how much homeowners can pay for their mortgages each month. Potential buyers find it harder to qualify to buy a home as rates rise. Higher rates increase the monthly payment needed to buy their home.
Until sellers are willing to accept a lower offer, many owners are shut out of the market. With a limited budget, they have to buy a smaller house, look in another area, or compromise on other factors. In some cases, they delay their purchase until they can find a better deal.
How to take advantage of rising interest rates
Although rising interest rates can negatively affect many parts of your portfolio, there are ways to benefit from higher rates. Here are some steps you can take to take advantage of rising interest rates:
Block your fixed rate debts: Where possible, convert variable debt to fixed rates to avoid higher payments.
Increase contributions to the pension plan: Stock prices may be more volatile during periods of rising interest rates. Increasing your pension plan contributions allows you to buy more shares at lower prices.
Search offers: As interest rates rise, some people cannot afford their rising payments. They may be willing to sell assets at a discount to pay off their debt.
Don’t Panic: With a comprehensive financial plan, short-term fluctuations in values shouldn’t affect your strategy. Follow the plan and discuss any potential changes with your advisor.
If you’re wondering what happens when interest rates rise, the answer depends on where your finances lie. Rising interest rates generally make all debt more expensive, while creating higher incomes for savers. Stocks, bonds and real estate can also lose value with higher rates. You can take defensive actions to help prepare for bad economic times while increasing your overall finances.
Tips for coping with inflation
A solid financial plan can help you prepare for inflation or an economic downturn. Having a financial advisor in your area can help ensure that you are prepared for any situation. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
Inflation is a silent killer for retirement portfolios. If your retirement income does not keep up with rising costs, your purchasing power will decline over time. Our Inflation Calculator predicts how the cost of items will increase over time due to inflation.
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