Interest rates do not make for the most exciting chat topic. You won’t find it in the conversation starter game that you unwrapped for Christmas. It’s probably easier to clear a room by yelling ‘Interest Rates!’ than FIRE! Watch your friends and family run from you as you broach the topic of how the Federal Open Market Committee voted to keep the Federal Funds Target Rate at 1.00% – 1.25%. Fed Prime Rate Info
Still reading? Good. Because interest rates impact your life.
We’ve been on an interest holiday since the Great Recession. The target range cited above is historically low. Mesopotamians paid higher rates in 3,000 BC. See Business Insider’s article: http://www.businessinsider.com/5000-year-history-of-interest-rates-2016-12
The almighty Federal Reserve controls the economy by regulating the interest rate. They can contract or expand the flow of money by adjusting the cost of capital. That’s a neat trick, isn’t it? Therefore, if you’re an investor or a consumer (translation: everyone), interest rate escalation may cramp your style. Here are five examples:
1. Cash flow decreases
Feel that tightness in your chest? That’s the cost of borrowing money. Interest rate increases tighten the economy and ruin everyone’s party. Businesses are less willing to make purchases, as are consumers.
Did you ever put a piece of plastic in the microwave and watch it disappear? That’s what happens to net profits. Available cash vanishes under crushing payments leaving slim-to-nothing profits.
Interest rates will eat your lunch. The increased interest cost on consumer loans leads to less household disposable income, less money to invest, and less money for charitable contributions.
Credit card companies do a happy dance as your high balance accrues ridiculous interest payments. Bonus tip: personal interest is not deductible on your tax return. If you’re maintaining a high balance, expect an increase in the interest portion of your bill if you’re not paying each month in full.
There goes your fancy ride. You’ll barely be able to afford gas after your monthly auto payment warrants a higher interest rate. Many auto loans are hovering around 3%. When I purchased my first car in 1986, my loan rate was 9.9%. Comparing 1986 to now, on a $10,000, 5-year loan, the difference in the monthly payment would be $32, an 18% difference.
At 3%: $180
At 9.9%: $212
That doesn’t sound like much per month, but over the course of the loan, the borrower is paying almost $2,000 more for the same purchase. That’s significant.
The same occurs with a home mortgage, only on a larger scale. The housing market is directly impacted as higher mortgage payments make home buying out of reach. As interest rates are increasing, there is typically a stampede to close on fixed mortgage rates. Adjustable mortgage rates should be avoided entirely when interest rates are in the swelling phase. The initial payment may be affordable, but as the rate adjusts, usually after the teaser period, payments become dangerously high leading to financial stress and foreclosure.
2. Stocks go down
The increased cost of borrowing spills over onto the cost of capital and goods. Subsequently, when consumers buy less, sales decrease. When this happens, stock prices dwindle.
The “market” is driven by emotion, not logic. As investors become fearful of the economic state, stock volatility ramps up. The Consumer Price Index (CPI) tends to reflect how happy the general public feels about the economy. The CPI is linked to interest rates and typically mirrors the pain felt by bloated interest rates.
Fundamental analysis of corporate stock prices is also sensitive to the interest rate. The fair market value of a share of stock is based on discounted future cash flows which should equal the investor’s required rate of return. The required rate of return is equivalent to a rate offered by a no-risk interest-bearing account. Therefore, if the interest rate increases, the value of the underlying company must compensate for the value. If the company’s fundamentals remain constant, the value of the stock will go down.
In addition, higher interest rates impact the corporation’s ability to service its debt. This may lead to financial distress. Debt paydown is a critical factor in evaluating the value of a stock. Therefore, the stock’s market value could suffer.
3. Bonds prices go down
Bond prices are married to interest rates, inversely. This occurs because the interest rate being earned on a bond may not be competitive with an interest rate of a no-risk account, such as a savings account.
Here’s how this happens. An investor buys a 10-year bond and earns 4% in interest income. Within the 10 years, the interest rate creeps up to 6%. The investor’s bond is locked in at 4% when s/he could be earning 6% in a savings account. The bond, like any other financial instrument, is subject to risk. A plain vanilla savings account has no risk. That’s why the value of the bond goes down. The investor is earning 2% below what they could earn if their money was invested elsewhere.
If the bondholder wants to sell their bond before the maturity date, they will most likely sell at a loss, due to the lowered value of the bond.
4. Fixed income earners get a raise
This is one that doesn’t hurt and (finally!) rewards savers. CD interest income and savings account interest income goes up. Retirees get a raise on their fixed income investments. That’s good news for them, because their investment income has been at the suffering level.
5. Consumer prices increase
The cost of borrowing money trickles down to product prices. Interest costs get baked into product costs just like rent, payroll, and utilities.
Enjoy the party while it lasts
I worry that consumers are getting complacent with the economy and the ease of available money. In response to record unemployment from the Great Recession, the Federal Reserve, or Fed, has been very generous with their economic posture. For almost 10 years now, the interest rate has been calm. Low interest rates have allowed companies and individuals to party like it’s 1999. Money is flowing and flying with everyone living a bountiful existence.
This is a fictitious reality that will end when the economy returns to normal. If you think things are tough now, wait until the Fed decides that interest rates should be higher.
What’s going to happen when interest rates rise (because they will)? Higher interest rates usually evoke grumpiness. Purchases may have to be postponed, reducing quality of life. To compound the financial squeeze of having less cash, paying interest expense is basically like throwing money into the wind because there’s no tax deduction for consumer interest.
What’s your plan for dealing with imminent financial dangers?
It should involve saving more than ever. A higher down payment for any purchase will keep your loan principal low, reducing the balance that interest is calculated on. When you have a loan, make additional payments toward the principal amount, even if it’s a small amount.
Debt and interest should be considered dirty four-letter words.