Investing Advice: How To Deal With Rising Interest Rates

Tips on maintaining financial health in the face of increasing interest rates.

You've listened to the sage words of Alan Greenspan and you've read the Money and Investing section of the Wall Street Journal. You think that interest rates are heading up. The question is: what can you do to prepare your finances for higher rates? And, once you've minimized risks to your financial health, how can you actually capitalize on the high interest rates to come?

- Lock in lower mortgage rates

Congratulations if you already have a mortgage with a low, fixed interest rate. But if you don't have a fixed-rate mortgage, obtaining one is the first thing you should do. When interest rates rise, payments on variable-rate mortgages rise. To avoid unpredictably large increases in your monthly mortgage payments, it is essential that you refinance your mortgage to a fixed-rate one as soon as possible.

Locking in lower mortgage rates has a corollary: stay in your current home. Mortgages and mortgage rates don't move with you. As a result, if you move, you may be forced to pay a much higher interest rate on your new home. Furthermore, high interest rates will reduce the amount of money you can borrow to finance your home, because lenders will take increased interest expense into account when determining how much you can borrow. This makes "trading-up" less feasible in a high interest rate environment and can make "trading-down" more expensive than staying in your current home.

- Speed up credit card repayment

In terms of credit risk, the individual investor is a far cry from the US Treasury. That's why individual investors pay interest rates of 20% or more on their personal credit card debt. You may think this is the highest rates can go, but in fact your personal interest rates will likely increase along with increases in rates on Treasury securities. To avoid the specter of ever-increasing and never-ending minimum payments, take the initiative on paying down your credit. You'll thank yourself when rates begin to creep up.

- Avoid long-term bonds

Advice to avoid long-term bonds during periods of rising interest rates may seem a bit surprising. After all, you may think, if interest rates are going up then fixed-income securities (like US Treasuries, for example) will be earning higher returns.

The problem with this logic is that you're expecting interest rates to continue to rise beyond current levels. When interest rates rise, the price of bonds falls. Let's illustrate with a concrete example. Let's say you buy a bond that pays interest of 3% per year. Then, interest rates rise so that a bond with similar maturity and credit characteristics will yield 5%. Who would want to buy your bond at face value when they could buy a bond with a 5% yield? The answer is - no one. If you want to sell your bond, you will have to sell it for less than you paid in order to attract buyers. And with a longer-maturity bond, there is a greater chance that you will want to sell the bond before it comes due. In rising interest rate environments, long-term bonds can lose you money.

- Purchase variable-rate securities

Your finances will be reasonably safe in an increasing rate environment if you have a fixed-rate mortgage, low consumer debt and few long-term bonds. But what if you want to do more with your money than just be safe? One of the best ways to capitalize on increasing rate environments is to purchase variable-rate securities. These are bonds whose principal and interest adjust based on prevailing interest rates (usually measured by a Treasury security or a standard European rate.) In addition to corporate bonds, some kinds of mortgage-backed securities are variable-rate as well. These types of securities will automatically pay you higher rates as market interest rates increase.

Nation-wide prevailing interest rates can have a big effect on individual investors and consumers. It pays to carefully examine your financial holdings in the event of a series of interest rate hikes and make appropriate changes to your financial habits.

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