With the Federal Reserve scaling back its massive bond-buying program, the likelihood of higher interest rates is causing a fair amount of hand-wringing.
Many investors have spent a great deal of time agonizing over what rising rates will do to their bond portfolios, but there are many other considerations. That’s because higher rates, financial advisors say, impact consumers in many other areas of their financial lives, both directly and indirectly.
Consumers who hold variable-rate debt will face higher monthly payments as rates adjust upward. As a result, millions of Americans will end up dishing out more each month to pay their credit card bills, home-equity loans and other accounts that have a floating rate. It will also cost more to finance big-ticket items, such as a home, car or boat, as rates tick up. Higher rates are also likely to change the calculus for many homeowners when it comes to refinancing mortgages.
Consumers will feel the sting of higher rates in more subtle ways, too. Rising rates push up the cost of virtually everything we purchase, from utilities to insurance policies, as companies pass along higher capital costs by raising their prices, experts said.
“You have to look at interest rates as the cost of money,” said A. Raymond Benton, a certified financial planner with Lincoln Financial Advisors. “Higher rates have a depressing impact on the economy because the cost of money goes up, and that flows through the whole economy, very much like a tax.”
Higher prices, advisors say, ought to prompt Americans to either make a household budget for the first time or to take a hard look at existing budgets to figure out how to save an adequate amount. As the U.S. economy improved in recent years, the country’s savings rate has generally trended downward.
According to the U.S. Bureau of Economic Analysis, the national personal savings rate — which is savings as a percentage of disposable income — was a mere 4.3 percent in January, while personal consumption ticked up slightly.
“When it comes to the normal ebb and flow of prices, whether that is food or energy prices, there is nothing anybody can do about it, much like the weather,” said Sean Michael Pearson, a certified financial planner and associate vice president at Ameriprise Financial Services. “What you can do is have a plan, and for most of us, that means having a budget.”
Ultimately, the amount of money consumers allocate to their retirement accounts has a greater impact on their financial health than incremental changes in interest rates, Pearson added.
“How much you are saving will make more of a difference in the long term than how much rates are rising,” he said. “If people spend a lot of time worrying about rising rates and don’t take the time to make a budget or figure out how much to save for retirement, that’s a concern.”
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Advisors are also reminding their clients who have yet to refinance their mortgages that interest rates are still at historical lows. Although mortgage rates have risen over the past year, the average rate for a 30-year loan was less than 5 percent in mid-March. The average rate for a 30-year fixed-rate mortgage was 4.32 percent for the week ending March 20, according to mortgage buyer Freddie Mac. Meanwhile, the average rate for a 15-year fixed-rate mortgage was 3.32 percent.
“Nobody can predict rates, and trying to do so is probably asking for trouble,” Benton said. “If you can still get a mortgage with a rate below 5 percent, at this point you probably shouldn’t be greedy.”
Given the uncertainty surrounding interest rates, consumers might want to think long and hard about taking out adjustable-rate mortgages, even if they seem cheap in comparison to fixed-rate loans, according to some advisors.
Adjustable-rate mortgages typically have a fixed rate of interest for a certain period of time — often five or seven years — but after that period, the rate on these loans fluctuates, at preset intervals, in tandem with a predetermined index.
In markets where home prices have soared recently, home buyers might be tempted by the lower initial rates of ARMs, figuring they can convert to fixed-rate mortgages before higher rates kick in. But that assumption has gotten many borrowers into trouble in the not-so-distant past, said certified financial planner Kent Grealish of Grealish Investment Counseling.
“If you don’t have the ability to handle whatever that reset rate, you might get into trouble, particularly if we have a soft real estate market and you can’t refinance your loan,” he said. “You need to consider how you will be impacted if your mortgage rate rises, especially if that coincides with some sort of big financial event, such as a job loss or reduced hours at work.”
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Some advisors say 7/1 ARMs may make sense for those who are close to retirement and plan to sell their homes relatively soon. Thanks to the low initial rates on these loans, homeowners nearing retirement can minimize their housing-related costs, freeing up cash for other purposes in anticipation of selling their homes, said certified financial planner Stephan Quinn Cassaday, president and chief executive officer of Cassaday & Co.
Cassaday said many of his clients who have mortgages are wealthy enough to pay them off early. However, they are generally better off investing the money they would use to do that, he added, given the expected spread between their investment earnings and after-tax loan costs.
“The amount of money consumers allocate to their retirement accounts has a greater impact on their financial health than incremental changes in interest rates.”-Sean Michael Pearson, certified financial planner and associate vice president at Ameriprise Financial Services
For someone in the 30 percent tax bracket, the after-tax cost of a 30-year loan with a 4 percent rate boils down to 2.8 percent, according to Cassaday. If their portfolio earns 8 percent a year, then the spread (or profit) is 5.2 percent, he added.
“There is an incontrovertible mathematic argument for having deductible mortgage debt. Most of our clients recognize the arbitrage,” Cassaday said.
Of course, there is some risk with this, he said, adding that investors should discuss this strategy with a qualified financial advisor before pursuing it.
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Despite all the uneasiness surrounding the issue of rising rates, Benton, of Lincoln Financial Advisors, and other advisors say higher rates up to a certain point are welcome change. Rising rates are an indication that the recovery is finally on solid footing, Benton explained.
Furthermore, some of the country’s most seasoned fixed-income investors expect rates to rise only modestly over the next few years. A return to more normal rates, he added, will ultimately benefit retirees and others who depend heavily on savings.
“Interest rates going up at a reasonable rate and returning to normal is not such a bad thing, even though it will increase the cost of car loans and other types of consumer loans,” Benton said.