What to do when rates rise?
Even in our years'-running, low-rate environment, it’s a fair question to ask.
Given the Federal Reserve has raised interest rates numerous times since 1980, it’s only a matter of time before it does again.
It’s an important question to think about for numerous reasons:
By getting answers now and planning your strategies before the inevitable rise in interest rates, you’ll be better prepared to move your money into savings vehicles that will keep pace with rising interest rates and inflation.
Before laying out these various steps and strategies, let’s briefly discuss why interest rates rise and why they might again in the future.
Why Do Rates Rise?
Typically, rates tend to rise as the economy heats up.
In an improving or expanding economy as demand increases for dollars, materials, labor, etc., their value and prices ride up as well.
When the U.S. economy hit the skids after the 2008 real estate meltdown, demand fell across the board and interest rates fell sharply.
Interest rates, of course, don’t fall by themselves.
As part of its mandate, the Federal Reserve largely controls short-term interest rates.
Short-term interest rates are loan contracts or debt instruments such as:
- Treasury bills
- Bank certificates of deposits (CDs), and
- Commercial paper having maturities of less than a year
These are often called money market rates.
By contrast, longer term rates are interest rates on financial instruments with a maturity longer than a year, such as a 15-year or 30-year mortgage.
Long-term interest rates are largely controlled by the bond market.
Raising interest rates balance economic growth; the cost of borrowing is increased but discretionary income is reduced, and therefore, the growth in consumer spending is limited.
Consider this table, courtesy of EconomicsHelp.org:
Effect of Increased Interest Rates
|Personal Effect||Economic Effect|
|Increased cost of borrowing||Currency will grow by making exports less competitive and imports cheaper|
|Improved return for savers||Inflation will tend to be lower|
|Increased cost of bank loans||Economic growth will tend to be slower|
|Banks may be more willing to lend||Unemployment could rise|
|Could reduce confidence in borrowers||Government will see rising borrowing costs|
The Strategies for Rising Rates
If you believe at all in the supposition that interest rates could be headed upward, then you owe it to yourself to develop a strategy for this potential rising-rate environment.
Here are the steps we recommend:
1. Know the Kind of Investor You Are
First, if you’re uncomfortable with the daily gyrations of the stock market:
Keep your money in a savings vehicle.
Any given day your net worth could just as easily fall as rise on the fortunes of a stock, so if that makes you a little bit too nervous, a savings vehicle may be a better choice for you.
Similarly, if you’re uneasy about investing in bonds:
Stick with a CD or other savings instrument.
In this case, prices as a rule fall when interest rates rise.
2. Stay a Little Bit Liquid
Liquid money is money that you can easily access from your checking or savings account.
This is money you can’t afford to have tied up.
Although you lose yield, you gain flexibility and access to move your money quickly in a rising-rate environment.
3. Think Short-Term
It’s easy to “chase yield,” which means investing in whatever savings instrument offers the highest yield on the day you visit your bank, in person or online.
But you might feel pretty foolish locking up that 2.5 percent CD for five years if interest rates suddenly spike to 3.5 or 4 percent.
So, stay shorter term with perhaps a 1-year or 3-year CD.
4. Make the Bank Share Your Risk
One way to make your bank share your risk is to take out a variable-rate CD, in which the interest rate changes during the product’s term.
If interest rates rise, the CD’s interest rate will rise as well.
Unfortunately, rates could also fall, and the value of your CD right along with it.
Most banks, however, offer a guaranteed return on
Another way is to invest in an adjustable-rate CD, also known as a bump-up CD.
Typically, the bank allows customers in rising-rate environments to increase their rate one or two times without extending the maturity of the CD.
For example, if you have a three-year adjustable with an annual percentage yield of 1.4, you might be allowed to increase the
For this added protection, the rate of return is lower than a regular CD.
5. Construct a CD Ladder
With stocks, some investors dollar-cost average, a technique of buying a fixed-dollar amount of a particular investment on a regular schedule, regardless of the share price.
More shares are purchased when prices are low, and fewer shares are bought when prices are high.
Building a CD ladder is somewhat similar because you also follow a schedule.
A CD ladder is a strategy for investing in CDs where an individual doesn't just invest in a single CD for a fixed amount of time, but instead "ladders" his CD investments over different maturities.
You might put $2,000 in a three-month CD, another $2,000 in a six-month CD; $2,000 in a nine-month CD; and the final $2,000 in a 12-month CD. This way, you spread your risk.
6. Our Final TIPS
TIPs stand for Treasury Inflation-Protected Securities.
Savers who seek protection from inflation, which is usually accompanied by rising interest rates, may want to invest in this
The way they work is your principal increases if inflation rises and your principal decreases if deflation occurs.
At maturity, you receive the adjusted principal or the original principal, whichever is greater, so, in a worst-case scenario, your original investment is always protected.
TIPS are issued in terms of 5, 10, and 30 years, and if the adjusted principal is less than the security's original principal, you are paid the original principal.
TIPS are sold at auction four times a year in $100
- 5-year TIPS are auctioned in April, August, and December
- 10-year TIPS in January, March, May, July, September, and November
- 30-year TIPS in February, June, and October
Final, Final Tip
No one knows where interest rates are headed.
As evidence, leading rate-watchers predicted that rates would rise and keep rising.
That’s where the safe money was heading, and then rates tumbled lower.
Yet history doesn’t stand still, nor do longstanding low interest rates, so you have to be prepared for any eventuality.