They Keep Yellen About Rising Rates: What you need to know

By Allie Eklund

Allie Ecklund
Allie Eklund

If you’ve picked up the Wall Street Journal, listened to NPR, or watched the news in the last two or three years, you’ve probably heard mention about the possibility of “rising interest rates.” There’s also a good chance you’re reading this thinking, “why should I care?” That’s a valid question. I’m here to break this down in the simplest way, because it’s not just banks and the elderly that interest rates affect. We all are impacted by interest rates. Here is the skinny on what you need to know, Skimm style:

 

THE WHAT

Interest rates can be explained as the price of borrowing money. When we buy on credit, we pay principal back, plus interest for borrowing money. Interest rates also relate to the investment incentive in buying bonds, also known as fixed income. A bond is a debt instrument issued by either a company or governmental body. When bonds are bought by investors, there is usually a stated interest the investor expects to receive in return. Bonds are known as being more conservative than stocks, or equity.

This amateur graph drawn below by yours truly shows that a bond’s price and its interest rates work inversely. When interest rates move up, a bond’s price or worth in the marketplace goes down. If you own a bond that pays you 3% interest, and suddenly the same type of bond is available for 5%, your bond investment is now worth less because it will be very difficult to attract buyers to your 3% bond when 5% bonds are available.

bond inverse with rates

 

Many of life’s major purchases involve credit, and therefore involve interest rates. Let’s use the example of borrowing to purchase a home, a mortgage loan. Mortgage rates have hovered around 4% lately. Let’s take a trip down memory lane… flashback to 30 years ago, “in the early 1980s, mortgage interest rates brushed the stratospheric highs of 18 percent and even 19 percent.” Interest rates have the ability to move, and not just incrementally. Historically, interest rates have been much higher than where they are now.

3.75-Interest-Rates-Chart

THE WHO

The Federal Reserve…aka “The Fed” is the United State’s central bank and controls the supply of money. What this means is if the economy is in a slowdown, the Fed may “loosen” money to encourage spending and borrowing. Loosening money theoretically kick starts the economy. The Fed has an ongoing goal to one, keep our economy stable and two, keep Americans employed. Janet Yellen is the current Chair of the Federal Reserve Bank and the first woman to hold this position. Appointed in 2014 to serve a four year term, she is the ultimate decision maker when it comes to the Federal Reserve policies. BFD.

Janet Yellen

http://blogs.wsj.com/briefly/2014/03/31/5-reasons-why-janet-yellen-still-sees-slack-in-econom

 

THE WHY

Naturally you ask “why are interest rates low?” Interest rates have been low in an effort to stimulate our economy since the 2008 recession. Lowering interest rates is one way to employ a “loose money” policy that promotes growth. As mentioned, the philosophy in lowering interest rates is that it should bring about consumer spending, but that wasn’t exactly what happened. So the Fed lowered rates, again. And again. And then again. For a while, our central bank was playing a game of “how low can you go” with interest rates.

Ultimately, this stimulant of lowered interest rates wasn’t strong enough. Additionally, the Fed purchased our Government’s own treasury bonds on top of bringing rates to all time lows. This is known as quantitative easing. I’ll keep it light- essentially QE was this falsified economic movement in the market. Remember when you had to sell all of those damn chocolate bars to raise money for soft ball, but none of your neighbors wanted your overpriced See’s Candy, so your parents bought every last piece? Yeah, that was QE.

federal funds rate chart

http://finance.yahoo.com/news/interest-rates-remain-low-2015-130058141.html

 

THE WHEN

What goes down must come up. Interest rates are likely to rise. No one knows exactly when. Yet, expecting an increase sooner than later wouldn’t be ill advised, as Yellen is “sticking with expectations for at least one rate increase in 2015.” But don’t hold your breath, our news channels have spent a great amount of time and money talking about when and how the Federal Reserve will raise rates for the last several years. There’s been a lot of talk and no walk.

 

THE HOW 

How will this affect us? Interest rates often drive consumer patterns. The upward move of interest rates means higher costs of borrowing over all- car loans, home loans, student loans, and that Nordstrom plastic APR. In terms of credit, if it costs 14% to buy those fall leather boots, versus 5%, we’re probably going to think twice about such a purchase. If buying a new car means paying a higher interest rate, it’s possible that more consumers will look to buy used cars that are more easily bought with cash. Think about it, as the economy recovered, albeit slowly, and interest rates stayed super low, this allowed many Americans to either get back in a home or buy a home for the first time. All of these behaviors, from the shoes to the roof over your head can be traced back to where interest rates currently stand.

It’s not just consumers that will face higher interest rates- it’s anyone or anything that borrows money. Start-ups and small businesses are often leveraged and rely on business loans to get moving towards profitability. With rates low, borrowing costs have been relatively cheap. If we see interest rates increase, we could potentially see slower growth for businesses.  

How will raising rates affect my investments like my 401(k)? If you have a bond heavy portfolio, you may want to review your investments with a professional and consider diversifying into investments that traditionally do better when interest rates move up. In the last few years I have reminded investors of three things to consider if they’re worried about rising rates having a negative effect on their portfolios: 1. consider stock- less susceptible to interest rate risk than bonds, investing in equity may be one way for you to diversify. 2. Go global. Investing overseas in regions of the world that are not tied specifically to U.S. interest rates can help desensitize your investments to interest rate risk. 3. Be short. If you must invest in fixed income, shorter the better during period of anticipated rising rates. Short term bonds historically have seen less price movement than long term bonds when rates have moved up.  

How will this affect my debt? Do an inventory of your outstanding debt. Touch base with which, if any debt is susceptible to changing interest rates. Think about credit cards or debt that doesn’t have a fixed rate. Pay this off first. On the flipside, if you are thinking that now is the time to make a big purchase that you’ll be paying a fixed interest rate, you may be right. With rates still being relatively low, locking in a fixed interest payment now could make a lot of sense.

 

So there you have it. The who, what, when, why, how of American interest rates. Boring? Maybe. Important? Yes. Understanding how macro finance affects our personal, micro lives is an important aspect of personal finance. And if nothing else, cheer on Janet Yellen for shattering a glass ceiling that was more like a vault before.

 

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