There is a lot going on in the world… and I have no good way of summarizing it. So, I’m just going to talk about one thing: the federal reserve (Fed) raising rates.
This issue is much more complex than I’m describing below, but this is my summary of how I see things.
Why are rates rising?
During the pandemic, Americans were in a bad place - I don’t think I have to tell you why. But, to help people stay on their feet, a lot of economic stimulus flowed into the economy like:
Increased unemployment payments
Enhanced and advance tax credits
“Loans” that were ultimately forgiven (i.e. free money)
The Fed paired this stimulus with another tool available to them; adjusting interest rates. They dropped interest rates to basically 0%, which impacts all borrowing costs. This includes mortgages, credit cards, car loans, etc.
The combination of cash available to spend and cheap borrowing rates that allowed individuals to spend even more, resulted in a lot of consumption.
This was great! The pandemic affected a lot of individuals and businesses, and the Fed wanted to encourage all this spending so the economy could continue, even through a global pandemic.
Clearly the combination of putting money in consumers pockets and keeping borrowing extremely cheap allowed for many people to not be shy about purchasing.
But this eventually went a little too far… the Fed rolled back those stimulus programs as the economy started to recover and find itself coming out of the pandemic. But, we’ve all seen the inflation numbers; cutting back the extra money to consumers wasn’t enough to curb the spending / inflation.
So, now it is time to focus on the other side of the equation.
In the most simple terms, when borrowing money is more expensive, people are less willing to borrow to buy things, which slows down the economy.
The Fed is increasing rates to encourage the slow down of purchasing. There is so much demand from all the extra money available, so the Fed is looking to lower demand by making spending much more expensive; especially on big assets that typically require debt, like cars and houses.
What are the benefits of rising rates?
The pretty clear benefit of rising rates is that your savings account can make more money. It won’t get as high as mortgage rates have… but it will bump up your savings or bond interest rates, which is nice!
For example, Ally Bank recently raised their savings rates from 0.50% to 0.90% - on $10k, this is an extra $40 per year. Certainly not life changing money, but it does incentivize us to save some, and we expect these rates to continue rising.
Second, and most importantly since this is the point of it, is that inflation should start to be curbed. As people are less open to borrowing and buying, prices of items should at least stabilize.
This isn’t to say that prices will crash or go back down, but they should stop rising at the rate they currently are. Especially big assets like houses and cars.
What are the downsides?
Well for those invested, all this uncertainty (and many other factors) has resulted in a ‘bear’ stock market. We are down over 20% of stock prices since the start of the year, and nobody knows when we will hit the bottom.
Additionally, for each upside of increased rates I mentioned, there is an equal and opposite reaction to the downside:
Variable interest rates will go up. If you have an adjustable rate mortgage or revolving debt with variable interest like a credit card, you may see your interest rates increasing.
It is expensive to buy a home and other assets that require debt. If you were planning on buying something, you may need to reconsider or make some cuts in your budget to afford the new cost of that asset.
How do I thrive in this environment?
I’m not sure anybody can thrive here, but there are some ways you can try to take advantage of these changes.
In my opinion, the best financial plan is one with a lot of flexibility. Some of my favorite pieces of advice right now:
Put your ‘safe’ money in higher yielding places. This includes considering Series I Savings Bonds and a High Yield Savings Account. Cash is losing to inflation, but there is no better alternative for financial and emotional stability; so keep it safe and available, but see if you can get a small return on it.
Assuming your financial foundation is strong, keep investing. Stocks are down, and you can take advantage of the markets by investing more. Bump your 401(k) contribution up 1%, add an extra $100 to your monthly investments, pre-fund your Roth IRA for the year, etc.
Hold your fixed (aka installment) debt. I’m not suggesting going into debt, but if you already have some debt, you probably got into it prior to this increase in rates, and now your lower interest rate is more valuable. Take advantage of this by making standard payments on that debt (in other words, don’t make extra payments to pay it down faster), and keep your cash available.
Reconsider big purchases. If you were planning on buying a house or a car, right now is a pretty perfect storm of high prices and high interest rates. Consider giving it a little time to see how this increase in rates affects asset prices.
Focus on your cash flow. Find ways to be more frugal, or increase your income. It is really important to be aware of your spending so you know how these increased rates affect you specifically.
Uncertainty brings a lot of fear, but the best thing you can do is focus on controlling what you can. Get back to the basics - emergency funds, focus on building / growing / protecting your income, and invest only if you have a long-term time horizon for that money.
Stock market losses are the cost of admission for investing - and that cost gets subsidized over the long-term by staying invested. Take advantage by adding money when you can, or just holding steady with your current investments. This market downturn will not make or break your finances, but your ability to withstand these downturns over your lifetime, will.
Higher interest rates benefit those that save, and hurt those spending above their means. If you think inflation hurts, imagine paying inflationary prices along with increased credit card interest.
Take this time as motivation to review your budget, your assets, and your debts, and work to optimize your balance sheet so you’re on the correct side of these interest hikes. Create a financial picture where you identify with the “What are the benefits?” section of this post vs. the “What are the downsides?”.
As Albert Einstein once said about compound interest; “He who understands it, earns it … he who doesn’t … pays it.”