What to Do About Low Interest Rates
- October 23, 2020
- by Michael
Interest rates are at an all-time low. The U.S. Federal Reserve has cut interest rates twice this year down to near 0%. This has left people wondering what they should do and what will happen in the future.
Whether you’re looking to minimize the impact on your retirement fund or maximize how far your dollar can go in a large purchase, there are several things you can do about the situation of current low interest rates.
Accept the Lower Return
It sounds boring, but sometimes the best thing to do is to stick to your plan. You can still continue to investing stocks, bonds, mutual funds, or other investments. Yes interest rates are low but there isn't anything the average person can do about it, so why stress over it?
Mentally you may want to reduce your expectation of your rate of return in the bonds category, but nobody knows by how much. Bond funds could still go up quite a bit if rates eventually go negative. As of 2020 negative rates are already the case in much of Europe, but it would be new for the US.
Accepting a lower return will help you either stay the course with your current investments or reduce worry if you’re just getting started.
Allocate to Cash and CDs
Money market accounts and CDs that are FDIC / NCUA insured are essentially risk free. Given that bonds carry a bit more risk, but have such a low return, CDs and money market funds are that much more attractive.
Banks run periodic specials to drag in business. Although it can be a lot of work to move the money around chasing an extra 0.2% here or there.
Given we live in uncertain times having a bit of cash on the sideline, or an expanded emergency fund may not be a bad idea.
Invest in Alternative Asset Classes
Although your bond funds might be earning exceptionally low interest, you can always increase your risk in the hope of getting a higher return. Your asset allocation is a very personal decision, but there is more out there than just stocks and bonds. Take time to speak with your financial advisor about different asset classes and if any changes to your allocation are in order.
Here are some ideas to spice up your asset allocation. Note we are not endorsing any of these approaches. Do your own research and weigh the risk vs reward on your own. When it comes to making changes, it may make sense to do it gradually. As we have written before - timing the stock market is like gambling.
- Treasury Inflation-Protected Security (TIPS) which are inflation protected US bonds.
- High yield bonds such as corporate bonds.
- ETFs that track high dividend stocks.
- Larger companies typically have higher cash balances, so stable large-cap stocks might have higher yields than your other investments.
- Precious metals which theoretically do well in inflationary environments, but they don’t pay a dividend, have storage costs, and are prone to speculation.
- Real estate investment trusts (REITs) ETFs and mutual funds are like buying a slice of a huge rental portfolio. REITs can offer high yields, but the underlying asset value can fluctuate dramatically (like in 2008).
Delay Social Security
Retirees are eligible to start collecting Social Security benefits any time between the ages of 62 and 70. The longer they wait, the higher the monthly benefit. Delaying taking Social Security is one of the few 'guaranteed returns' available.
When interest rates are low delaying social security benefits makes more sense. That is because the benefit of waiting provides a much higher compounded return compared to what bonds provide. However waiting may not be possible given available retirement savings and budget.
Refinance Your Mortgage
The Fed lowers interest rates to promote spending in the economy. Doing so also drags down mortgage rates. The lower the mortgage rate the lower the payment for a given house.
At this point you might want to consider refinancing if:
- You have owned your home for more than five years.
- Your income has increased recently.
- Interest rates have dropped.
- Real estate has appreciated significantly in your area.
The savings that comes with refinancing your mortgage can be significant.
For example, let’s say a home was purchased five years ago with a $250,000, 30-year fixed-rate mortgage. At that time interest rates were an average of 4.08%. The monthly payment would be $1,205 (not counting taxes and insurance). Without paying additional payments the buyer would pay $433,835 in total over 30 years.
Now, rates are much lower! Refinancing the remaining balance of $225,000 over 30 years at a record low rate of 2.9% comes out to a new monthly payment of $937 (excluding taxes and insurance). The buyer would pay a total of only $337,146 throughout your new 30-year fixed-rate mortgage.
In this example, refinancing leads to a total savings of $100,000, and $268 in free cash flow each month.
One thing the example ignores is closing costs, which is the fee you pay to get the loan put through (appraisal, bank and title fees, points, the commission to the loan officer, etc). It is wise to pay attention to closing costs when shopping for a mortgage loan. That said a difference of a thousand dollars would amount to a rounding error in the above example.
Refinance and Consolidate Other Debts
If you took out credit card debt or student loans at a high interest rate, you might be able to reconsolidate now at a much lower interest rate. For example, if you took out a private student loan at over 5%, you might be able to refinance it at as low as 2.5% interest and have the option to change the term on your loan. Changing the term means that if you were making large monthly payments over five years, you could refinance your loan to be repaid over ten years to help make your monthly payments more manageable.
If you have several credit cards with balances that are gaining interest, you might want to consider consolidating those as well. Some credit cards charge over 25% interest each month and managing multiple payments can be confusing. By consolidating, you can bring all your payments into a singular monthly payment. Some credit cards offer a 0% APR on balance transfers, which can also help you pay off your balance faster.
Invest in Yourself or Your Primary Residence
With interest rates this low, it might make the most sense for you to keep your money out of the market. Instead, you might want to use your money to invest in yourself. As Benjamin Franklin said:
“An investment in knowledge pays the best interest.”
This might mean enrolling in a degree program or earning an online certificate.
You could also consider remodeling your home, which would give you sweat equity in an inflation protected asset.
The Bottom Line
Low interest rates are an excellent opportunity to refinance your debt to pay less over time. They can also be an excellent opportunity to reassess your investment strategy to ensure that your retirement fund grows over time. Before making any significant financial decision, it is best to weigh your options and speak with a financial advisor to ensure that you are making changes that will positively impact your financial future.
Image "limbo" by Paul L Dineen is licensed under CC BY 2.0.