What Rising Interest Rates Mean for Your Money
Rates went up again. You’ve heard it on the news so many times it’s become wallpaper. But behind that headline is a quiet transfer of money, and whether it flows toward you or away from you depends on a few choices most people never get around to making.
Where “rates” actually come from
When we hear that interest rates are increasing, we can almost always count on the fact that the U.S. Federal Reserve will have increased its short term benchmark (the overnight lending rate for one bank borrowing money from another). The banks then use this as a reference point when determining how much to offer you on your savings account or how high of an interest rate to charge you if you want to borrow from them. So, the benchmark interest rate is determined by the government and there’s virtually no financial account with which you don’t feel some impact from changes in that rate.
How one rate moves your money
The savings account gap nobody checks
Here’s the part that should make you sit up: when rates rise, banks are quick to charge more for loans and slow to pay more on savings, especially the big traditional banks. Plenty of them still pay a fraction of a percent on savings while online banks and credit unions pass most of the increase along on the very same kind of federally insured account. Same insurance, same money, wildly different pay. On a $15,000 emergency fund, that gap can be hundreds of dollars a year for filling out one online form.
Locking a rate in while it’s high
You may be able to lock in a higher yield on your deposits if you’re willing to give the bank or other financial institution some time, (usually several months to a couple of years), but this will cost you something, namely flexibility. If you do have funds that you know you won’t use during a certain period of time, then locking today’s rate into place through either a Certificate of Deposit (“CD”) or Treasury Bill could make sense for you. With each case there’s also another “cost”, with CDs, it’s the ability to withdraw your money as needed; with T-Bills, it’s losing interest until maturity. It wouldn’t be good to ever tie-up your emergency funding source(s) since emergencies don’t come at convenient times, especially when they require immediate attention or action from you.
What rising rates do to your debts
Now it’s the other side of the ledger. Your credit card interest rate varies based on the benchmark that the Federal Reserve sets, so when the benchmark goes up, your credit cards’ Annual Percentage Rate (APR) will follow soon after, which means that even though you may not have used your credit cards since last week, you just got hit with an increase in what you pay per month for carrying that outstanding balance! On the other hand, a fixed-rate mortgage is locked into place as of the date that you signed the contract for that loan, which is why consumers love to hang onto those low fixed-rate loans. So, if you’re carrying variable-interest rate debt during a time when interest rates are going up, paying off this debt ahead of schedule has a greater return on investment than almost any other use for that money.
The mistake to skip
When savings finally earn something it’s very attractive to put everything in those accounts and consider that your long-term investment strategy. For a short period of time for those funds you’ll use in an emergency or within the next year that’s correct. Historically savings accounts have been very close to inflation, while long term investment returns are generally higher than both. A good way to think about this would be to consider how jobs work; savings accounts help protect money you’ll need shortly, investments grow money you won’t need until many years from now. With interest rates increasing it means that protecting your money will finally earn at least enough to match what you can make by growing your money with investments.
Three moves worth an hour this week
- Look up what your savings account actually pays, then compare it with a high-yield account. The gap is often the easiest money you’ll make this year
- If a card balance is riding a variable rate, put it first in line for payoff
- Sitting on cash you won’t need for a set stretch? Price a CD or Treasury bill for that window and lock the rate in
None of this needs a finance degree. It needs an hour, once, and the willingness to stop letting your bank decide what your patience is worth.
What a CD ladder does for you
There’s a trade-off with a certificate of deposit. You get to keep the current rate for as long as you like, but in return you have to let the money be. The downside of tying up all your funds in one long-term CD is that an early withdrawal will cost you, and when rates go up there’s nothing to be done about it. The way to work around that’s with a CD ladder. Take $15,000, for instance. Rather than shoving it into a single five-year CD, you divide it up and put it to work in five separate ones, with maturities at one, two, three, four and five years. Come time for you to mature, you have some liquid capital on hand to use or to put toward a new five-year CD.
The ladder means you are never far from some of your money, and you keep reinvesting at whatever rates the future brings instead of betting everything on today’s. It is a quiet, unglamorous strategy, which is exactly why it works for money you want safe but still earning something real.
Treasurys and I bonds, in plain terms
If the higher rates are any indication, it’s time to consider some of the savings offerings from the feds. Take Treasury bills, for instance: they’re short-term government debt and about as secure as you can find. On top of that, the interest is free from state income tax. A matter of a few weeks is all the time needed on some of these, and they’re available via a broker or by going to TreasuryDirect.
Then you have I bonds. They’re in a class of their own, designed to put a lid on inflation. The rate is adjusted on a semi-annual basis to follow the market, which is a good way to make sure your hard-earned dollars don’t lose value as prices go up. Of course, there are some stipulations. You can put in as much as $10,000 a year per person via TreasuryDirect, but you’re on the hook to keep the bond for a minimum of a year. If you decide to liquidate in under five, you’ll be out the final three months of interest. But for funds you have no intention of getting at for some time, it’s a fair price to pay.
When rates turn back down
There’s a limit to how long rates can go up. The very strategies that are of use today will have the opposite effect down the line. As the Fed begins to lower them, you can expect banks to be swift in reducing the yield on savings; a rate that’s attractive now may not be for much longer. For funds you have no immediate use for, it makes sense to put them in a CD or an I bond and make sure you’re holding onto a favorable rate before it’s gone.
If you’re on the borrowing end of things, a dip in rates is as good a signal as any to consider a refinance. You may be able to put some of the pressure off a mortgage or other fixed loan that was put in place when rates were up, but only if the numbers work out and the savings are worth more than the closing costs. It’s a good practice to make time for it: whenever rates shift one way or the other, put in an hour to figure out what it does to your bottom line, be it for what you have put away or what you owe. There’s always an impact to be had.
Rate words, decoded
The terms behind the headlines
- Benchmark rate
- The figure the Fed puts in place, and in turn, what moves the rates on bank savings and lending.
- APY
- The annual percentage yield: the true rate of return on an account after compounding is factored in. A good way to put one offering up against another.
- High-yield savings
- Your run-of-the-mill, federally backed savings account, often with an online institution, that will put a large conventional bank to shame on what it pays.
- CD
- A CD. You’re in for a fixed rate over a period of time, but there’s a cost if you want to get your money out before the term is up.
- Treasury bill
- A no-brainer for safety: a short-term loan to the U.S. Government with interest you don’t have to pay state tax on.
- I bond
- Inflation-protected federal bonds. The rate is adjusted to keep up with rising costs so your hard-earned money retains its value.
Sources
Photo by Andre Taissin on Unsplash
