| What interest rates mean to you
Interest rates. You hear about them on the news, see them in ads for cars and mortgages,
and find them screaming for your attention in all of those credit card offers that
land in your mailbox. But even if you’re not looking to finance a major purchase, interest
rates can still affect virtually every aspect of your financial life.
The cost of borrowing money
When interest rates rise, it costs more
to borrow money. Mortgage interest
rates are tied to the yield of the 10-year
Treasury note. Credit card and home
equity interest rates are most often set
based on the prime rate,1 which is in turn
based on the fed funds rate.2 So when
you hear that the Federal Reserve has
raised the fed funds rate, you can expect
credit card interest rates to rise as well.
The payoff for saving money
On the other hand, rising interest rates
generally mean that you’ll earn more on
bank savings accounts and money market
accounts. These types of accounts
are often used for short-term needs. If
you’re looking at keeping money in these
accounts for the long term, you should
consider whether the interest rate they are
paying will help you stay ahead of inflation.
For example, if your savings account
is paying 2% interest, but inflation is
increasing at 4% a year, you may actually
be losing purchasing power.
The economy
Inflation – or lack of it – often drives the
Fed to use interest rates to help either
boost or slow the overall economy. If it
feels that inflation is a threat, the Fed
can raise rates in an effort to cool off
the economy and potentially keep price
increases in check. If it feels economic
growth is too slow, it can lower rates to
encourage more borrowing and spending,
in order to rev up the economy.
Interest rates can also affect the value
of the dollar in the global economy: the
dollar’s value can weaken if U.S. interest
rates are too low to attract investors from
other countries.
Your investments
Movements in interest rates can also affect
your investments. Because higher interest
rates often come in response to inflation,
they may signal that corporations are facing
cost increases that may negatively affect
their stock prices.
Bond performance is more directly linked
to interest rate movements. When interest
rates rise, prices of existing bonds generally
fall because new bonds are paying
more interest. The opposite is also true:
when interest rates go down, the prices of
existing bonds generally go up. Read more about how interest rates affect bonds.
A bond portfolio checkup
Changes in interest rates don’t necessarily
mean it’s time to bail out of bonds or bond
funds. Depending on your risk tolerance and
investment objectives, you might want to
consider investments that include:
- Short- or intermediate-term bonds - which are generally less affected by interest rate changes than longerterm bonds.
- High-yield bonds - which tend to be affected more by changes in their credit rating than by interest rate changes. Keep in mind that these bonds also tend to be more volatile.
- Foreign bonds - which are not directly affected by U.S. interest rates.
- A flexible approach - that can incorporate these different types of bonds in one investment.
- Expert managers - who have experience managing bond investments in changing rate environments.
However, just as there’s no one-size-fits-all bond investment, there’s no single answer to investing in a changing interest rate environment. Your financial advisor can be the source for an investment plan that makes sense for you, no matter where interest rates are headed.
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