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What to Do (and Not Do) With Rising Interest Rates

Article

The Fed’s recent announcement that it will increase the Federal Funds Rate is a good opportunity to evaluate your investments and financial position. But it’s no time to panic.

On Dec. 16, the Fed raised their key “Federal Funds Rate” (the rate at which banks lend to each other overnight) from a range of 0% to 0.25% to 0.25% to 0.5%. It appears clear that if economic conditions allow, they will continue to slowly raise rates over the next couple of years. Many investors are wondering what they should do (if anything) about all of this. Proposed ideas range from reasonable to apocalyptic. However, a bit of humility with regards to your ability to predict future economic events will go a long way. Let’s first discuss a few things to do about this rise in interest rates and then a list of things not to do.

Enjoy Making Something On Cash

In 2007, I earned over 5% nearly risk-free in a money market fund. For the last five years, that same fund has a had a return of essentially 0% per year. I eventually abandoned it in favor of a high-yield online savings account paying 1%, still well less than the rate of inflation. Personally, I am looking forward to having my cash savings at least keep up with inflation again.

Put Yourself in a Position Where Rising Rates Are a Good Thing

Not everyone is hurt by rising interest rates. If you have no need to take on additional debt, this is mostly a favorable economic condition. Anybody who has obtained a fixed rate mortgage in the last five years may soon be earning more on their savings than they are paying the bank to borrow. Unless you have variable rate loans or need to take out loans in the future, there is little downside to rising rates. Even if you still have need to borrow in your future, mortgage rates will need to rise 5% just to get back to the rate at which I took out my first mortgage in 1999. We’re a long way from there.

Refinance If You Haven’t Already

If you do have some higher interest rate debt that you could refinance, now is the time to do so. This includes both mortgages and student loans. Since 2013 it has become possible for physicians to refinance their student loans again. In fact, starting in 2015, even residents can refinance their loans while enjoying lower payments than government programs offer during their training. If you do not expect the loans to be forgiven or paid off by someone else, why not refinance now and lower the cost of that debt? Likewise, if you have been dragging your feet on refinancing your mortgage, now is the time. Even after the Fed’s announcement, it is still possible to get a 15 year fixed mortgage under 3% and a 30 year fixed mortgage under 3.5%, both essentially historical lows.

Now, let’s talk about a few things you should not do.

Don’t Rush To Refinance Variable Loans

While it is nice to have a fixed rate on your mortgage or student loans, bear in mind that there is often an advantage to a variable rate. When you take out a fixed mortgage, you are in effect paying an insurance premium against rising rates. As a general rule, you should only buy insurance for financial catastrophes, and self-insure everything else. If a rise in interest rates would not be a financial catastrophe to you personally, it is reasonable to run that risk yourself. For the last several decades, those who have used variable rate loans have been rewarded for that taking that risk. For example, if you can refinance your student loans to a fixed rate of 4% or a variable rate of 2%, interest rates not only have to rise for you to lose, but they have to rise over 2% AND they have to do so quickly, before you’ve paid off most of the loan. Variable rate loans not only outperform in a time of stable interest rates and a time of falling interest rates, but can also outperform in a time of slowly rising interest rates. Only if rates rise dramatically and quickly do fixed loans outperform. If you expect to pay off loans in less than five years, and can afford to make the payments should they unexpectedly rise quickly and dramatically, there is no need to pay that extra “premium” to get a fixed rate.

Don’t Panic About Your Bonds

Many investors are panicking about their fixed income investments. As interest rates rise, the value of bonds generally falls and vice versa. However, over the long term, fixed income investors benefit from higher rates. Duration is a financial term that tells you how long it will take for a bond investor to break even after a rise in bond rates. For example, an intermediate term bond fund may have a duration of five years. If rates rapidly rise 2%, a holder of that bond fund should expect to lose 10% of the value of those bonds. However, the bond fund would then pay a 2% higher interest rate. In five years, the investor would have made up his losses and the rest is gravy. So unless your investment horizon is less than five years, a rise in interest rates is beneficial.

Don’t Pretend You Can Predict the Future

Some investors have chosen to keep the duration of their fixed income holdings very short over the last five to eight years. Thus far, they have not been rewarded for that decision. Over the last five years, the Vanguard Long-Term Treasury fund has had returns of 6.78% per year, while a similar intermediate term fund has made 2.56%, and the short term fund made 0.74%. It’s difficult to make predictions, especially about the future. While a consensus of economists expects rates to go up something like 1-2% over the next one to two years, their track record is less than reassuring. Besides, this expectation is already priced into the bond market. If you expect to profit by changing from long-term bonds to short-term bonds just before interest rate rises, and then switch back, you’ll need to get the timing right not once, but twice. That will require you to know more than the market does, which can be a very difficult task. I would instead recommend you write down a fixed asset allocation and stick with it for the long-term. When interest rates fall, be grateful that the value of your bonds went up. When interest rates rise, be grateful that future expected returns from those bonds will be higher.

Don’t Make Wholesale Portfolio Changes

Perhaps the greatest error investors make out of fear of rising interest rates is to make dramatic portfolio changes. Classically, rising interest rates have meant lower returns for stocks. However, that correlation can be very low. In fact, since 1998, rising bond yields have been correlated with HIGHER returns for stocks. Classically, rising interest rates are also bad for gold and other precious metals, since there is higher opportunity cost to hold them. However, the price of gold has fallen 41% since 2011, without any increase in interest rates. Perhaps the effect of rising interest rates is already “priced in.” Even with Real Estate Investment Trusts (REITs), highly leveraged companies considered quite sensitive to interest rates, it turns out that correlation between rate changes and returns is much higher in the short term than the long term. In short, it is far better to hold a diversified set of assets that is likely to perform well in any future economic environment than to make large bets dependent on your ability to predict the future.

Thanks to recent action at the Fed, general interest rates are likely to rise over the next two years. Following a well-thought-out long-term financial plan will keep you from panicking or making moves you will later regret.

Dr. Dahle is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.

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