What to do when rates rise? Even in our years’-running, low-rate environment, it’s a fair question to ask because the Federal Reserve has raised interest rates 67 times since 1980 — so it’s only a matter of time before it does again.
It’s an important question to ask whether you’re saving for a down payment on a house or a car, planning a big vacation, or trying to build up your child’s college tuition fund.
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 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, which 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.
Why rates could rise soon
Since the Great Recession officially ended (June 2009), the U.S. economy has been rebounding. Since October 2009, when unemployment peaked at 10.0 percent, the rate has fallen to 6.1 percent in September 2014. Reflecting this improvement, there have been six straight months of at least 200,000 jobs created, and the nation’s gross domestic product (measuring all the goods and services our economy produces) grew at a stronger-than-expected 4 percent in the second quarter of 2014.
Not a day passes without economic polls and surveys trying to gauge both consumer and business sentiments, and, generally speaking, the outlook has been increasingly positive. All of these factors are a recipe for rising interest rates, especially when compared to current rates that have been skipping along their rock bottom. For example, the Fed’s key funds rate (the Fed-set rate at which banks loan one another money) is between zero and 0.25%. You can’t get much lower than that. Thus, rates have a lot more upside potential than downside.
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:
Step 1: Know the kind of investor you are
First, if you’re uncomfortable with the daily gyrations of the stock market, where on any given day, your net worth could just as easily fall as rise on the fortunes of a stock, keep your money in a savings vehicle. Similarly, if you’re uneasy about investing in bonds, whose prices as a rule fall when interest rates rise, stick with a CD or other savings instrument.
Step 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.
Step 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.
Step 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 principal for variable-rate CDs (when held to maturity), which protects customers from actually losing money in a down market.
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 rate up to 2 percent. For this added protection, the rate of return is lower than a regular CD.
Step 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. 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.
Step 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 hedge instrument.
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 sold at auction four times a year in $100 allotments, or can be purchased on the secondary market at any time through banks and brokers.
Final, final tip
No one knows where interest rates are headed. As evidence, leading rate-watchers predicted that rates would rise at the start of 2014 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.
What to do when rates rise? Now you’re prepared to answer that.