When Interest Rates Head Up


It doesn't take any skill at prognostication to make this forecast: Interest rates are heading up. For one thing, they can't go any lower.

Whether you think rising interest rates is good or bad mainly depends on whether you're a borrower or a lender. If you run a small business that depends on credit to buy raw materials or inventory, then rising interest rates are bad news. If you're a member of the rentier class and live on interest and dividends, then rising rates will be a boost to your income.

Of course, it's an over-simplification to speak of "interest rates" as if they all moved together. There are lots of interest rates, and some of them behave very differently from others. In particular, although we talk about "low" interest rates, there aren't many borrowers who can actually borrow at low rates — just governments and large financial institutions, really. Mortgage rates have been pretty low (for well-qualified borrowers), and some car loan rates have been low as well. Other consumer rates, though, never fell much to speak of. Rates for borrowers with poor credit started high and stayed that way.

Still, whether you think rising interest rates is a good thing or a bad thing, it's sure to happen, so you need to be prepared.

Dealing with rising rates

When rates are rising, the rule is this: borrow long and lend short. Now might be a fine time to lock in a good rate on a 30-year mortgage, but do not get an adjustable-rate mortgage, even if the rate seems like a great deal. Similarly, don't start putting your money into 30-year treasury bonds. (Inflation-adjusted Treasury paper may be an exception.)

When will rates go up? I don't know. Probably even the members of the Federal Reserve Open Market Committee don't know, and they're the folks who decide. At their last meeting they left intact the language that said that rates would stay low for "an extended period." People have been assuming that this means at least 6 months. A couple of members have started talking about the need to get rates back to "normal" levels, but just a day or two ago someone at the San Francisco Fed suggested that near-zero rates might be appropriate until 2012.

I do know this: once rates start going up, they will keep going up for a very long time. To me, that means that locking in rates for the short-term (6 months or even a year) will be harmless. Yes, it will mean that you won't be participating in the higher rates the instant that they go up. But, since rates will keep going up, when your CD (or whatever) rolls over a few months later, you'll get an even higher rate.

My take on it is that you needn't hesitate lock in for as long as year, if you can get a better rate than you can get on cash. But I'd definitely draw the line before 2 years. Once rates start up, rates on 2-year paper will move up sharply. You wouldn't want to have to wait 15 or 20 months to take advantage of that.

Finally, once rates do start moving up, don't be in any hurry to lock in the new higher rates. Interest rate cycles tend to be very long: The current cycle of declining rates has been running for almost 30 years (since 1981). I wouldn't be surprised if, once rates start going up, they kept going up for just as long.

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Guest's picture

Great stuff--I agree completely.

Basically, I know nothing about economics, except for two things.

One, the economy (along with interest rates and everything else) runs in cycles, and it is very idfficult to do anything to alter these cycles.

And two, in the end, its all a crapshoot.

Philip Brewer's picture

It's easy to start thinking that way—that market moves in the real world are so unpredictable that they might as well be random—but I think it's a mistake.

The point is not to predict the future, the point is to align your personal finances with the broad trends. Get the little things right (spend less than you earn, focus your spending on what you care most about, find work worth doing), and your household can carry on pretty much regardless of these sorts of broad macroeconomic events.

Guest's picture

Nice advice on short term CDs! I'd say stick to anything below 12 months at this time (6 month would be ideal). Then, when rates start increasing I'd look into building a CD ladder to stay in front of the trends and, finally, right before interest rates peak again (such as they did before the market burst of '08) you should move into long term CD's to lock in higher rates to last through the downswing. For example, if you locked in a 5 year CD in Sept of 08 you could have gotten close to 6% APY which would have carried you through Sept of '13. Now the top 5 year CD's are barely paying 2% APY.

Personally, I would think rates are going to remain this low through at least the rest of the year (esp if the dow keeps zig zagging above and below 10,000).

Guest's picture

Well I feel fluctuating interest rates are always a worry for people who have debts! Especially students who have student loans to repay! If the rates are high then it is a matter of concern.

Philip Brewer's picture

Yes, I have (perhaps) an uncommon perspective, because I have investments but no debt, so higher rates mean more income to me, rather than more expense.

Student loans are an interesting case. I don't have any current information, but back when I got my student loans, the interest rates were fixed. So, rising rates didn't hurt graduates. (If you were still in school, rising rates could mean that your next-year's loans were at a higher rate, though.) Is that no longer true? Are student loans at variable rates that will rise when rates eventually go higher?

Guest's picture

when the interest rates start to rise the feeble recovery will fall harder than an ice hockey players head!!
The banks are giving money to themselves at minus zero interest and they still don't want to share the wealth, when the rates start to rise the double dip will gain momentum...

Guest's picture

Its amazing that rates have stayed so low for so long! Now that Bernanke stated that rates will stay low until at least Mid-2013, gives savers little hope for an increase in rates. I guess its good for home buyers but the rest of us are left to wait.. and wait

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