How Rising Interest Rates Affect You

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interest ratesSince 2008, the Federal Reserve (the Fed) has increased the federal funds rate 3 times.  The rate went from an all-time low of 0.25% to the current rate of 1%.  For those not familiar with the Fed, they set the rates in which banks can borrow from other banks to cover the Fed’s requirements.  

 

So, if a bank loans out too much money for the day, it would have to borrow some money from another institution to cover these requirements.

 

interest ratesThe Fed is projected to raise interest rates twice more in 2017.  In 2018, we can expect rates to rise 3 times.  Most people are unaware that these rate hikes will affect them.

 

Let me share five ways these increasing interest rates may affect you in the future.

 

Interest Rates on Savings Accounts

year in review raise child without debtFor those of us that use a savings account to store an emergency fund, the account’s interest rate could increase.  I’m not necessarily suggesting that a 0.25% Fed rate increase would affect your savings account immediately.  But, I do figure that the banks would want to shore up some of their profits.  My guess is that by the end of 2018, if the Fed continues to raise rates, that you will begin to see a higher return on your savings account due to increased competition among the banks for customers.  

 

Most banks assume customers are lazy and won’t change banks for small differences in interest rates.  But I can tell you from first-hand experience that I did so because of a 0.25% difference.  It also helped that I hated my previous online bank’s interface, so I had been actively looking.  Given the ease in which it is to open up an online bank account, I’d probably continue switching banks, if it was advantageous.

 

Interest Rates on the Dollar

interest ratesWhen interest rates go up, foreign investors typically flock to the US dollar.  This, in turn, strengthens the dollar against foreign currencies.  For those of us who would like to travel overseas, that means we get a bigger bang for our buck.  I’m definitely looking forward to enjoying an affordable European vacation in the future.

 

On the flip side, a strengthened dollar could potentially hurt exports and may cost the US some jobs.  It may be cheaper, at that point, to import certain items instead of manufacturing them here in the US.

 

Interest Rates on Bonds

democrat vs republicanIf you are an existing bondholder, you probably have been in shock since President Trump’s victory.  The 10-year treasury rate jumped from 1.77% to a current value of 2.32%, which has put tremendous pressure on the bond market.  So bondholders are probably not thrilled to see the announcement of rate hikes from the Fed coupled with Trump’s win.  

 

Each time the Fed raises interest rates, you can hear a collective groan from existing bondholders as their investments drop in value.  Who would want to receive $1.00 in interest from an existing bond, if you could buy a new bond that paid interest of $1.25?  Therefore, the current bond value would get discounted until the value lined up with the $1.25 interest-paying bond.  So following that example, the $1,000 bond that you’re currently holding, if you were to sell it, would be only worth $977.

 

Interest Rates on Stock

Most people assume that when interest rates rise that the market will go down.  Pundits will scream the list of companies to sell when interest rates go down.  Somehow they also know the right companies to buy when interest rates go up as well.

 

These pundits hypothesize that it will be more expensive for companies to procure capital.  In turn, there will be pressure on the company’s bottom line.  But as most of you know, these active investors guess wrongly 75% of the time.  Otherwise, they’d be somewhere else counting their heaps of money.

 

interest rates

Willis Investment Counsel, http://wicinvest.com/

 

As you can see, stocks actually perform slightly better overall during periods of rising interest rates versus the average period of time.  

 

interest rates

Willis Investment Counsel, http://wicinvest.com/

 

Once again, you can see that the S&P 500 returned slightly more when interest rates peaked versus when interest rates bottomed out.

 

So don’t listen if someone tells you to sell all your stocks because of rising interest rates.

 

Interest Rates on Homes

interest ratesAs most of you know, my wife and I have been casually looking at homes out west.  I am always astounded at the home prices in my area.  At times, it seems like the housing crisis never hit the DC area because housing continues to rise and rise.  While my current home value is increasing, I know that just means everything else around me is also rising at a similar rate.

 

Recently though, interest rates have started to tick up.  There is an old adage that if you can take the 10-year treasury rate and add 1.7% to it, you’ll have a pretty good idea of current mortgage rates.

 

Right now, the 10-year treasury is 2.3%, so you should expect to pay somewhere around 4% for a 30-year mortgage.  

 

From my rudimentary understanding of economics, when interest rates go up, the amount of mortgage that someone can afford goes down.  

 

The Effect of Interest Rates on Mortgage Amounts

Interest Rate Mortgage Payment Mortgage Payment based on $1,432 Percentage Difference
4% $1,432 $300,000
4.5% $1,520 $280,000 (7%)
5% $1,610 $265.000 (12%)

 

As you can see, when the interest rate increases by 0.50%, the monthly mortgage payment also increases and the amount of house that someone can afford potentially decreases.

 

Therefore, I also made the assumption that home prices would drop, since home buyers would have to take out a smaller mortgage with rising interest rates.  With my downpayment readily available, I thought I would have an advantage by being able to make an all-cash offer.

 

Here’s the thing about that assumption.  It’s wrong!!!

 

When Interest Rates Rise, Home Prices Rise

interest ratesSince 1976, whenever interest rates have increased by 1% or more, home prices also rose.  

 

Do you know when housing prices fell?  When interest rates started to fall.  This is due to the fact that when people feel good about the economy, they buy houses.  They feel secure in their job and are willing to spend big bucks.  

 

As crazy as this sounds (sense the sarcasm), the Fed normally raises interest rates when the economy is doing well.  When people feel confident, the demand for houses rises, despite the fact that interest rates are also rising.  

 

So while I would love to see home prices fall due to the rise in interest rates, I won’t be holding my breath.  

Readers, what do you think?  Had you considered each of the ways that rising interest rates could affect you?

Mustard Seed Money

Welcome to the website. A mustard seed is a very small seed but astonishingly grows very large over time. My hope is that through your financial journey that your small investment in time, money and faith will grow beyond anything that you could ever imagine.



44 Comments

  1. Interesting points, especially on the relationship between interest rates and home prices. I would have thought the opposite were true.

    Personally, I try not to worry about what the Fed will do or predict when they’ll raise the rates. I’m just sticking with my investment plan. Although it would be nice to see interest rates on savings and money market accounts go higher.
    SomeRandomGuyOnline recently posted…2017 First Quarter UpdateMy Profile

  2. What will also be interesting to see is the inflation figures in the future. Are the house prices you checked real or nominal increases? I’m not sure how the high US inflation in the ’70s-’80s does impact the figures on both stock and real estate returns.
    I think nowadays many investors hold dividend stocks as a kind of bond replacement. But once (and if) the bond interest rate increase further, I think many people would sell those stocks and buy safer bonds instead. My investment horizon is quite long so I wouldn’t sell my stock holdings, but I guess I would buy more bonds from new investment money in such case.
    The exchange rate effect is also interesting. Logically thinking what you’re writing on a strong US dollar makes sense, but at the moment the EUR/USD has climbed back almost to pre-election levels. Economy is kinda complex I guess 🙂
    Roadrunner recently posted…April 2017 Investment IdeasMy Profile

    • Hahaha…I definitely agree the economy is way more complex than the pundits try to break it down to. If they were so smart they would have made billions off of smart trades. But they’re working for a living talking on TV 🙂

  3. It’s actually not that much of a shock. The fed is raising rat s to slow down how quickly the growth in inflation. With some notable exceptions the price of things (inflation) increases in good times. Hence the fed raises rates then. That all being said we’re talking about .75 increase. To put that in perspective the rates were around 5 in the late 90s. And I’m not even cherry picking a hig year.
    FullTimeFinance recently posted…The Right and Wrong Reasons to become and EntrepreneurMy Profile

    • I definitely remember. Crazy to see where we are now. I’m sure there aren’t any economists that would have predicted where we are now with interest rates 🙂

  4. Since I borrow to Invest, every increase 0.25% interest rate costs me and extra $250 annually per $100,000 that I borrow. It may not seem like a lot, but it’s the extra return that I have to make to cover that increase. Lucky for me, I Iocked up my loans for a five year term at a fixed interest rate of under 3% and I don’t have to worry about interest rates going up until 2020.

    If my interest cost is more than 5%, I’ll start to liquidate my investments and start to pay back some of my loans and repeat the process when interest rate is going down again. It may or may not happen, but If it cost me more than 50% of my return in the form of interest cost to borrow to invest, it becomes too risky and I will need to lower my leverage.
    Leo T. Ly @ isaved5k.com recently posted…Raising Financially Responsible KidsMy Profile

    • Thanks for sharing Leo!!! I appreciate your insight, since you definitely leverage debt to increase your portfolio 🙂 Interesting read to see how it directly affects you!!!!

  5. In my experience with real estate, you always hear the mantra “location, location, location.” So, while the numbers you cite here are obviously for the country as a whole, real estate is inherently local. Like DC, I came from an expensive area. Not as expensive, but up there. Only bad weather seemes to impact the housing market. Bucks County, Pa in general was pretty insulated regardless of the rest of the US. Now where I am in Gettysburg, PA, I don’t think much moves at all and interest rates aren’t going to do much. Things just don’t move fast (holds true for the drivers in the area too). So, I think the numbers help illustrate an overall picture, but it really depends on each area.
    Dave @ RunTheMoney recently posted…Saving for a Down Payment? Why You Need 20% DownMy Profile

    • You are absolutely right Dave!!! It’s definitely an overall number and not location specific. I was talking to co-worker who thinks that real estate is going to die a slow painful death and become a depreciating asset. We’ll see 🙂

    • Thanks for sharing The Magic Bean Counter!!! I hope to take advantage of it when/if we ever get to Iceland 🙂 Hopefully it’ll work out well for us!!!

    • Thanks for stopping by Mr. Defined Sight!!! I definitely agree that we are in a much better situation. I definitely don’t want to move back where we were in the late 70s/early 80s 🙂

  6. Being in the personal finance space, I’ve been watching The Fed do their rate hike thing this year. Fortunately for us, we’re set in our house and won’t be buying anytime in the near future. We’re also stashing cash like crazy people in our index funds – which will hopefully go up. We also wouldn’t mind jet setting around Europe over the next few years 😉 And with that, I say bring on the hikes!

    • Thanks for stopping by Mrs. Mad Money Monster!!! I’m with you. I’m stashing the cash and getting ready to jet set in a couple of years 🙂 Can’t wait to explore the world on the cheap!!!

  7. I’ve been thinking more and more about this point and it’s interesting that contrary to intuition, housing prices actually go up when interest rates go up.

    One thing that is interesting is the 10 year hasn’t come up. One of the indicators we look at in our models is the 10 year minus 2 year Treasury spread. If the spread hits 0, then that has signaled a recession the past few recessions.

    Thanks for sharing, you always come up with well thought out and thorough posts.
    Erik @ The Mastermind Within recently posted…How To Create Passive Income Making Websites With Fiverr Service ArbitrageMy Profile

    • Thank you for the kind words Erik!!! It definitely takes a little bit of time to put things together but I figure if my wife can read it and not get bored, I figure it’s acceptable 🙂

  8. Interesting article MSM!

    Was surprised at the performance of the stock market with high interest rates. It makes there would be more competition in reducing capital costs. Weighted Average Cost of Capital in accounting, can be key reducing expenses and more people may switch over to selling equity in a higher interest rate environment.
    -A Rising Tide Lifts All Ships

    Henry

    • Thanks for stopping by Henry!!! I feel like I always here how great it is when the Fed lowers rates for the market but it was definitely interesting what the numbers said 🙂

  9. The rates are definitely up, but still very low. I think once things are at 6 or 7 percent, people’s actions would really change.

    The question is – will they go up 2% more? It doesn’t seem like any time soon. So I’m not too worried about it affecting me.
    Brian – Rental Mindset recently posted…Let’s Get EducatedMy Profile

    • Thanks for sharing Brian!!! It’ll be interesting to see how high interest rates go up. Hopefully not too high. I don’t want inflation to run rampant 🙂

  10. The day after Trump one, my bond fund dropped by about 3%. It was just a temporary thing though. I do have to be alert about interest rates moving forward because I currently have a 7-year ARM so will have to hope that in the next few years rates rise but quickly fall back enabling me to refinance.
    SMM recently posted…Should I Even Invest in The Market Right Now?My Profile

    • Thanks for sharing SMM!!! I know bonds took a beating right after Trump won but seem to have stabilized a little bit now. Should be interesting to see where they go from here 🙂

  11. We have been looking forward to a small increase in the miniscule interest rate we get on our cash reserve for a long time. And we hope to NEVER TAKE ANOTHER MORTGAGE AGAIN…EVER! So, selfishly, we hope interest rates creep back up a little. But I guess as we look to our kids who may sometimes need to take out a mortgage of their own, that would be bad for them. We just can’t control it, so I can’t worry about it. Nice read, MSM!

    • Thanks for stopping by Mrs. Need2Save!!! I wouldn’t mind if interest rates rose and paid a bit more in cash, although it’d be nice if inflation was zero during this period as well 🙂

  12. I feel pretty well positioned for a rising interest rate economy. I would rather enjoy getting something more like 3% on my savings account. And home prices rising with no current plans to move for another 15 or so years makes me not too worried. BUT, I do own some bonds and I recall my parents talking of tougher times when rates were double digits. So, some of my optimism might be ignorance. My dad told a story of his first closing for his first home in the ’80s. The joke at the table was would mortgage rates ever be single digits again. LOL.
    ReachingTheCrest recently posted…What if You Knew Everyone’s Net Worth…and They Knew Yours?My Profile

    • Hahahha…I can’t imagine paying double digits for a mortgage these days. But my parents tell me all the time how they always paid at the highest interest rates when buying houses. Seems like forever ago that we came anywhere close to those 🙂

  13. Hi MSM,
    Interesting charts in there! The biggest impact for us on raising interest rates (if they ever get round to it here in the UK that is) will be our mortgage payments when we come out of our fixed period.
    Right now, I am just gently tickling it down with a few extra payments – rounding up the monthly amount to the nearest 50, ticking off the income from my other half’s account (that I Invest in for tax reasons). Knocked almost a year off our term so far, and long may that continue!
    In terms of investing – I am in accumulation mode, so I will ignore it mostly for now, although if they start getting very high then I may start buying some bonds!
    Cheers,
    FiL
    FIREin’ London recently posted…The 2016/17 (Tax) Year PerformanceMy Profile

  14. Great read. We are traveling overseas in July and are looking forward to taking advantage of the stronger dollar. The last trip we had overseas (about 5 years ago) the exchange rate was much different, and not in our favor. Interest rates can also affect student loans, as rates increase so will the rates on student loans. With student debt at approximately $1.4 trillion each rate increase makes it harder for new borrowers to pay back those loans.
    Courtney @ Your Average Dough recently posted…How to Save (and Make) Money While TravelingMy Profile

    • Thanks for sharing Courtney!!! Sounds like you’ll definitely enjoy the stronger dollar on your trip 🙂

      Also great point about student debt and the increase in interest rates!!!

  15. There’s a misconception on the Fed’s impact on interest rates. The only rate the Fed impacts is the Fed Funds rate, which is the rate at which banks lend money to each other overnight to meet minimum reserve requirements. Outside of this short-term rate, the market sets long-term rates. So the Fed raising interest rates doesn’t necessarily impact the rate on your 10 year bond.

    Since the election, rates have gone up as there is more optimism in the market that decreased taxes and regulation will lead to economic growth. When the administration failed to get healthcare passed recently, rates went down (10 year treasury dropped from a recent high of 2.60% in March to 2.18% just a few weeks ago) because the market believed this would push out tax reform and hinder the growth everyone was optimistic about. Fast forward a few weeks later and a new tax plan has been rolled out, some of that optimism is returning, and as a result long-term rates are going back up. There’s still a lot that needs to be worked out in congress to pass the new tax plan. If it starts to falter, then we’ll see long-term rates drop again.

    On your final point, the reason why the Fed raises the Fed Funds rate when the economy is doing well is to control inflation. As the economy heats up, so does inflation. One of the tools the Fed has to control inflation is raising the rate that banks borrow money from one another. This essentially makes borrowing money more expensive for the banks, which has an intended effect of decreasing the money supply and lowering inflation.

    As for me, I want rates to rise at that means the economy is doing well as is the stock market. My mortgage rate is locked in, so the only impact to me banking wise is an increased rate on my savings account (I miss the days of 2007 when my money market account paid 4.75% interest). We’re also planning some overseas trips in the near future, so the better the dollar is doing the less I’m spending, unlike when we went to Europe a few years ago.
    Go Finance Yourself! recently posted…Why Real Estate Gains Vary So Much By LocationMy Profile

    • Thanks for sharing Go Finance Yourself!!! I definitely agree with what you wrote above as well missing the high interest rates when money markets were around 5%. I feel like people would park all their money there if they could now 🙂

  16. How are you approaching investing with the interest rates potentially going up? I keep reading about many people decreasing their exposure to bonds. I would think if you are a long-term investor, higher interest rates will be better for bondholders because they have a better return long term.
    I guess we should go back to our IPS and just follow the rules and not pay attention to all the noise.

    Tom @ HIP

    • Thanks for stopping by Tom!!! I haven’t changed any asset allocation to my portfolio. I thought it was interesting to see the results but like you I’m going to not pay attention to the noise 🙂

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