When interest rates rise, it's all over the news. But sometimes it's hard to understand what those rising rates mean for your personal finances.
It's not all bad. Home and vehicle loans become more expensive, and credit card interest rates might also be on the rise. But there are some positives, as well. Interest on deposit accounts like savings and CDs can also increase, and that can be beneficial to your savings goals.
But how does a rising rate environment affect long-term goals like investing for retirement? If interest rates are rising, do you need to make changes to your investment strategy?
Interest rates 101
Let's start with defining what an interest rate is, and how it affects our economy.
An interest rate is the amount charged or earned for a loaned amount of money. If you have a savings account or a certificate of deposit (CD), you earn an interest rate in the form of an annual percentage rate, or APR. The higher the rate, the more you earn.
The opposite is true for amounts of money that you borrow. For example, when you get a mortgage, the higher the rate, the more it costs you per dollar borrowed. Check out current mortgage rates.
The Federal Reserve sets interest rates. They adjust the federal funds rate, which is the rate that banks use to loan money to each other. All other interest rates are also based on this rate. That's how it trickles down to the consumer.
In addition to affecting your mortgage and car payments, it can also affect your investment portfolio.
How do bonds react to rising interest rates?
Interest rates affect stocks and bonds differently. When interest rates rise, the value of a bond decreases. But this is only what we call a paper loss, because if you hold it to maturity, you get the entire value back.
For example, if a $1,000 bond is purchased and rising interest rates cause it to decrease in value to $900, as long as it's held to maturity and it does not default, the investor gets $1,000 back.
In the bond market, bonds with shorter maturities are usually less affected by interest rate changes than those with longer maturities.
Here's how you can think about how interest rates affect bonds. If you're holding a bond with a 5% coupon, a bond word for the interest rate, and interest rates increase and new bonds are issued offering 6%, that makes my bond at 5% less attractive, so its price decreases.
Most people would prefer to receive 6% versus 5%. And the inverse is true if interest rates decrease.
To understand what happens to stocks when interest rates rise, it's helpful to understand why interest rates rise.
Interest rates often rise during times of fast economic growth. It's a tool used to help control inflation. Typically, this means stocks face headwinds and investors can expect slower growth. Slower growth doesn't always mean no growth.
Here are three wealth management points to keep in mind during times of rising interest rates:
If interest rates are rising due to inflation, one sector can be affected more than another. For example, even though high inflation may cause the cost of groceries to rise, most people will not cut back on eating. But they may cut back on entertainment to offset the rising costs of groceries.
Likewise, in inflationary times, investments in companies like grocery store companies probably won't be affected as much as investments in leisure-focused companies like a cruise line, a leisure-focused ETF or a mutual fund.
When bonds and CDs increase how much they pay, they can become more attractive than the stock market, from a risk perspective. For that reason, investors might leave the stock market in favor of bonds or even CDs. If the stock market is returning 5% and you can get a CD paying 4%, then why take on the extra risk for just an additional 1%? That's simply a hypothetical, but it makes the point of why this occurs.
There is fear of the unknown. Trying to match the return of years past in today's market might be hard to accomplish without taking on extra risk. In investing terms, past performance is no guarantee of future results. The last time inflation was as high as what was experienced in November 2022 was back in 1981. It's been a long time since we've faced this, and it's causing fear among some.
Because of this fear of the unknown, people may feel skittish about leaving their money invested or nervous about entering the stock market to begin with. Are you wondering if you should invest your money or save it? If so, check out 5 steps to help you decide.
How do rising interest rates affect cash equivalents?
Cash equivalents are things like savings accounts, CDs and money market funds.
As we mentioned earlier, when interest rates go up, banks tend to pass that benefit on to consumers. This enables people to earn more on money they've set aside for short-term goals in accounts like a savings account.
While the goal of your emergency fund savings isn't to earn money, earning money while it's sitting there isn't a bad thing.
So how to invest when interest rates are rising?
Now could be the time to consider different investment options to achieve financial goals. These options could include:
- Individual bonds versus bond funds.
- Treasury bonds or notes.
- Real estate investment trusts, or REITs, which tend to hold up well or even outperform during times of rising interest rates.
- Preferred stocks versus common stocks.
Since preferred stocks behave like a hybrid of stocks and bonds, rising interest rates affect them more than common stocks. This is an important point to consider when thinking about an investing time horizon.
As always, continue to focus on long-term growth with the understanding that investments may lag or even decline in the short term. Remember risk tolerance and risk capacity, and invest according to those and your personal goals.
When volatility occurs is not the time to discover you've chosen the wrong ratio of stocks to bonds to cash, leading to a portfolio that's too risky or volatile for your risk tolerance and capacity. On the flip side, investing too conservatively can limit an investor's ability to reach their long-term goals.
If you need help striking the right balance for your personal finances, don't hesitate to speak to a qualified financial advisor who can answer your questions and help guide your investment strategy.