Tips for Using Low Rates to Your Advantage
On March 16, 2020, the Federal Reserve cut the Fed Funds rate from 1.00-1.25 percent to 0-0.25 percent,1 and that rate cut has made ripples throughout the entire financial system. Following are six ways you may have been impacted by the change in interest rates.
1. The rate of return on relatively safe investments
This is probably the most obvious change, but it has a significant impact. The investment vehicles investors rely on for safe returns, such as certificates of deposit (CDs), savings accounts, and high-quality government and corporate bonds, are now offering very little return.
On January 1, 2020, you could loan the U.S. government money for 10 years by purchasing a 10-year treasury bond and earn 1.8 percent on your money every year for 10 years, then get your money back. Today, if you purchase a 10-year treasury bond you will only earn 0.68 percent each year, a decrease of over 60 percent.2
This is important because it affects all other borrowing. If the U.S. government will pay you nearly 2 percent each year and is considered the least risky option for you, than a company or bank would need to pay you more than 2 percent to make up for the additional risk they represent relative to the government. Today, they only need to beat 0.68 percent, so they will not be willing to pay you 4 or 5 percent interest as they had in the past.
2. Home prices and purchases
Mortgage rates are also impacted by the change in interest rates. At the beginning of 2020, 30-year fixed rate mortgages had interest rates of approximately 4 percent. Today, they are near 3 percent. If you were considering buying a home at the start of the year, with current rates, you would be able to afford a more expensive home for the same monthly payment amount. The following table compares the impact of the 1 percent reduction in mortgage rates.
3. Lower expenses
Even if you are not in the market to buy a new house, the lower mortgage rates may allow the existing homeowner to lower their monthly mortgage costs by refinancing. An opportunity also exists to look at other existing debts such as car loans or credit card debt and possibly consolidate and reduce interest cost.
4. New business and new projects for existing businesses
When a company is determining whether or not to launch a new product or service, it runs an analysis of the probability of success and profitability. One key input into the calculation is the cost of capital, typically a combination of debt and equity. As mentioned earlier, the cost of debt has recently dropped significantly, therefore lowering the hurdle rate needed for a project or product to be deemed viable.
5. Valuation for growth companies relative to value companies
When you purchase shares of a company’s stock, you become a partial owner of that business and its future profits. In determining a fair price for that ownership, you may consider future profits and then discount them back to a present value. In other words, you consider what you are willing to pay for future anticipated, but unearned, profits in today’s dollars.
Now, suppose you are considering two options. Option A has steady and consistent profits (a value company) while Option B has lower profits today, but those profits are anticipated to grow significantly in the future (a growth company). When you are discounting future profits back to present value, the effect of lowering the interest rate will benefit both Option A and Option B but will be significantly greater for the growth company, Option B, making it more likely that you will choose that option.
6. Appetite for speculation
Historically, a balanced portfolio is represented by a mix of 60 percent stocks and 40 percent bonds. The problem many investors now face is that the 40 percent allocation to bonds is not delivering enough safe income to meet their needs, and allocating more to stock would add too much risk and volatility to the portfolio. In their search for alternatives, investors are presented with many options, including precious metals, crypto currencies, wine, art, and more. For each of these options, there are advocates who will present a case for why the future price will be higher than the current price and how now is the time to buy. In the current low-interest-rate environment, investors may be willing to take the risk of investing in speculative alternatives.
No one knows for certain how long these very low interest rates will last, but as of October 12, 2020, the Federal Reserve provided no indication that it will be making changes anytime soon.3 Given the Fed’s goal of keeping inflation at reasonable levels and unemployment low, the current economic situation provides both opportunities and challenges. How people navigate these opportunities and challenges may have a significant impact over both the short and long term.
At Creative Planning, we work to ensure each client’s portfolio is structured to weather an ever-changing economic landscape. Our teams will work with you to understand your specific goals, opportunities and challenges in order to develop a financial plan to guide you toward achieving your personal financial objectives. Contact us today to learn more.