When you're just getting started with financial planning, rising interest rates may seem like a bad thing. After all, you've always learned that the best time to buy a house or car is when interest rates are low. While low-interest rates have their benefits, there are many ways to make a rising interest rate work in your favor, too.
Learning the financial basics can be tough when there are so many opinions out there. Taking advantage of interest rates may require a mindset shift and a new perspective on what you already know. In fact, you may be surprised to learn that there are opportunities to improve your investments when interest rates increase.
Using rising interest rates to build your financial portfolio may not seem intuitive. However, there are many ways that you can use higher interest rates to boost your investments. Read on to learn everything you need to know to take advantage of rising interest rates.
How Do Interest Rates Work?
As a consumer, you've probably encountered interest rates before. Every time you apply for a loan or credit card, you receive an interest rate. Have you ever wondered how a financial institution determines your rate?
You may think your interest rate is based on your credit score, but that's only one factor that determines your rate. The base rate is usually based on the Federal Reserve's Fed Funds rate, which is determined based on the strength of the economy. While the Fed Funds rate doesn't directly impact a credit card or mortgage interest rate, many companies follow the Federal Reserve's (or, the Fed's) lead when defining rates.
Generally, a rising Fed Funds interest rate shows faith in a strong economy, while a lower interest rate indicates a weaker economy. When interest rates are low, it's less expensive to borrow money since the value of a dollar is decreased. That can urge people to spend more readily on big-ticket purchases, ultimately boosting the economy.
However, this can also mean that demand outpaces supply in certain markets. Higher demand can lead to inflation, or higher prices for the same items. The Fed lowers interest rates as a way of reducing or avoiding inflation, so Americans can still afford necessities even when the economy is struggling.
As people spend more money, the economy may strengthen, leading the Fed to raise their rate. In a stronger economy, companies often start producing more goods and offering more services. That can boost both international and domestic business, as both companies and consumers feel more financially secure.
Once the Fed sets an interest rate, financial institutions often use that rate as the base number for fixed and variable interest rates. From there, a bank or lender's unique underwriting uses other factors like your credit score to decide what interest rate to offer you.
How Do Rising Interest Rates Help Investors?
When you're primarily a consumer, the financial basics may point to rising interest rates as unfavorable. As an investor, though, anticipating higher interest rates offers more opportunities to make money.
As you build your financial portfolio, watching spending trends while interest rates are low can reveal where consumers may be spending their money as the economy improves. As news of imminent interest rate increases comes in, look where spending is heightened to choose where to invest. For example, if streaming services retain or grow their customer base during a recession, it may be worth investing in technology companies and TV providers as interest rates rise.
While rising interest rates do not directly affect stock prices, increased spending can have an impact on predicting market winners. For example, certain industries like tech, healthcare, and financial firms frequently rise and fall alongside interest rates. However, investing as interest rates rise goes beyond playing the stock market.
Here are some great ways to get extra cash flow to your portfolio as the economy gets stronger.
Buying Property to Flip or Rent
Many hopeful homeowners looking to sell list their homes when interest rates are low. Since mortgage rates are lower, buyers come out in droves to consider new homes before the interest rate increases. But did you know that an interest rate hike may work in an investor's favor when buying property?
When interest rates are rumored to rise, some homeowners may be eager to leave their homes before prospective buyers dry up. That means they may be willing to knock down listing prices and negotiate more to get a sale. This is a great time to buy lower priced homes to flip.
When interest rates rise, supply outpaces demand in the housing market. Often, interest rate hikes lead to a buyer's market, where homeowners may be desperate to sell and move out. When negotiations are in your court, you can buy a house for less than its worth and cover some renovation costs with credits.
Renovating your investment home during a buyer's market can allow you to sell the home in a seller's market for exponentially more. A Home Advantage advisor can help you find the perfect home for your budget and to make the home buying process easy.
This is also a great time to secure a lower rate on an investment property and become a landlord. As the economy gets stronger, rent prices may increase, so your investment may be worth much more over time. Even with a slightly higher interest rate, rising rent prices can accommodate the increase in your monthly mortgage amount.
When fewer people can qualify for mortgages, you can use your impressive financial profile and credit score to build your real estate portfolio. Fewer mortgages leads to more renters, which allows rent prices to increase. Buying a rental property right when interest rates rise can give you time to renovate the property and list your rental units at a premium price.
Refinance Adjustable Rate Investments
When interest rates are low, taking advantage of adjustable rate investments is a good idea. However, as rates rise, you may get stuck with an increasingly bigger bill if you have an adjustable-rate mortgage (ARM) or variable-rate student loans. As interest rates begin to rise, now is the time to refinance and lock in a lower rate.
It may seem counterintuitive to refinance when you're accustomed to such a low rate. When the economy is growing, your loan's low rate can extend far beyond the base rate you initially agreed to if it's not locked in. Once you've taken advantage of that low introductory rate, a fixed rate refinanced loan may ultimately put more money in your pocket for the coming years.
Before you jump to refinance your loan, make sure you check the fine print. Some variable-rate loans come with a pre-payment penalty which will also apply to refinancing. Confirm your loan details with your servicer and consult your wealth management professional before you move forward.
Invest in Bonds
While the stock market may be unpredictable during an interest rate increase, bond yields are a safe and secure bet. Investing in bonds as interest rates rise can lead to a steady rate of return you may not be able to find elsewhere. Securing bonds during times of rising interest rates can be a great way to pad your portfolio and balance your risk.
A diversified portfolio almost always includes bonds, and bonds deliver a higher rate of return when interest rates are higher. Bonds offer a reliable income stream and aren't as susceptible to market volatility. Generally, bonds are a smart investment when interest rates are high, as that will increase the value of the bond's payout over time.
Bonds may be priced lower and deliver a higher rate of return based on the interest rate. However, if interest rates continue rising, you may find yourself with a lower-valued bond than what's currently available in the market. Creating a bond ladder can help you take advantage of interest rates and avoid some of the downfalls of bond investing.
You can also look into investing in Certificates of Deposit (or CDs), which are a type of bond offered by banks and credit unions. These are a great way to take advantage of rising rates while securing a modest return rate over time.
If you choose to invest in the stock market after an interest rate hike, you may want to balance your risk by adding some short-term and mid-term bonds to your portfolio, too. Some long-term bonds like Treasury Inflation-Protected Securities (TIPS) may offer an even higher rate of return by retaining your bond value over time. Work with a financial advisor to help you determine when is the best time to buy individual bonds or bond funds.
Consider Trading Foreign Currency
If you have a trusted advisor or feel confident in your trading abilities, investing in foreign currency (also known as Forex) amid rising American interest rates is a smart move. Higher interest rates mean the dollar is stronger. A stronger dollar leads to better exchange rates between foreign currencies, allowing Americans to make more money by exchanging currency as interest rates rise.
Day trading may seem intimidating to someone who has never explored it. However, it's a great opportunity to use America's strong financial position to your advantage.
Trade profits may be higher after an interest rate hike. But, this market can also be affected by foreign politics and how the rest of the world responds to the US interest rate hike, too. If you're looking to start Forex day trading, learning the basics before an increase can help you take advantage of a smart investing moment.
Save More Money
Investing money isn't the only way to take advantage of higher interest rates. A high-yield savings account or money market account can help you make money by saving for a rainy day. Accruing dividends through saving can put you in a better position to invest when interest rates dip back down.
If you're looking to make a big purchase soon, saving now and paying down debt can prime you for getting a mortgage, car loan, or student loan to go back to school. Borrowing money when rates are low is a smart financial decision, so if interest rates are rising, it may be best to wait and save your money.
A smart investment strategy always includes personal savings. Using this time to fill your piggy bank can position you to invest more in the future, even if you aren't getting huge returns right now. Work with your financial advisor to consider the best strategy for your family.
Know the Financial Basics of Using Rising Interest Rates
The financial basics of investing may seem counterintuitive when you don't have years of experience under your belt. Everyone needs to start somewhere, and learning to take advantage of rising interest rates early can mean a lot more money in your pocket over the years.
Start exploring your investment options before the Fed raises their rate. If you're looking to make your money work for you, this overview is a great step beyond basic financial planning into a comprehensive investment strategy. Once you have basic financial literacy down, there are a ton of opportunities for you to make more money even when the economy is strong.
Shifting from a consumer mindset to an investor mindset can be tricky without help. Working with a trusted advisor can help you make intelligent investment decisions right from the start.
If you're ready to start using rising interest rates in your favor, become a member of iTHINK Financial today. We can help you get started investing for your future and making your money work for you.