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Since 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.
The 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
For 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
When 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
If 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.
As you can see, stocks actually perform slightly better overall during periods of rising interest rates versus the average period of time.
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
As 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|
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
Since 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.