It looks increasingly as though 2013 will mark the first year of rising interest rates since 2009, making it only the second year of rising rates in the past seven. Interest rate movements can dominate investment returns in everything from plain-vanilla saving accounts to stocks, so a turn in the interest rate trend means you may need to rethink some of your financial strategies.
In some ways, this could mark the end of an era. Five-year bond yields reached a high of nearly 16 percent in 1981, and during the next 31 years they made their way steadily lower, eventually bottoming out at 0.62 percent in July of last year. Most people, then, aren't used to making financial decisions in a rising-rate environment. However, since rates fell down to nearly zero, there really wasn't anywhere else for rates to go but up.
Preparing for rising rates
Here are five ways you can adjust to this change:
- Lock in your mortgage rate. This means most people should avoid an adjustable-rate mortgage, because these could send your mortgage payments spiraling in a rising-rate environment. It also means don't buy a house that you have to struggle to afford, in the hopes you may get a chance to refinance down the road. There's no guarantee that you'll see lower mortgage rates than today's.
- Keep your CD terms short. Flexibility is key, so your rates can rise along with the market. However, that doesn't mean you should abandon CDs altogether in favor of savings or money market accounts. Deposit rates tend to rise pretty gradually, so as long as you don't lock into CD terms lasting several years, you should get an opportunity to roll over at higher rates before you've missed out on too much interest.
- Watch the spread between CD rates. Another reason to avoid long-term CDs at the moment is that as interest rates fell, the spread between long- and short-term CD rates collapsed to less than 70 basis points. That spread may start to widen as interest rates rise and if it does, that could be a signal to start considering longer CDs again.
- Readjust your asset allocation. It isn't just interest-bearing bank accounts and bonds that are affected by interest rates. Stocks have benefited tremendously as those 30 or so years of falling rates have made stock dividend and earnings yields look steadily better by comparison. In contrast, as rates rise it will create something of a headwind for stock valuations, and it could also create a drag on economic growth that hurts stock earnings. Therefore, as bond and saving account yields become more attractive, you may want to adjust more of your asset mix away from stocks and toward interest-bearing vehicles.
- Make sure your bank isn't behind the curve. With any trend, some institutions get out in front while others lag behind. If your bank is slow to respond to a rising-rate environment, it could cost you money on your CDs, savings and money market accounts.
Higher interest rates may prove a challenge to an already-sputtering economic recovery. They will be welcomed by savers, but cursed by borrowers. Whatever your situation, you can make the best of it if your decisions reflect these turns in the interest-rate tide.