Making the Most of Low Interest Rates
Predicting the course of interest rates has become an exercise in the Boy Who Cried Wolf.
Ever since the economy began to dig its way out of the financial crisis, the expectation was that the artificially low interest rates that arrived in late 2008 would begin to rise. “We’ve been hearing that rates had no where to go but up, yet that’s not what’s happened,” says Luke Delorme, director of financial planning at American Investment Services, the investment affiliate of the American Institute for Economic Research. “What we know for sure is that interest rates are unpredictable.”
The Federal Funds, the key short-term interest rate controlled by the U.S. Federal Reserve Bank, was drastically slashed from above 5 percent to near zero percent during the financial crisis in an effort to keep the economy from tanking. And it’s barely budged from there.
Last December the Fed raised its Fed Funds rate a smidge to less than 0.40 percent though it has been unwilling to raise it since. The interest rate charged on credit cards and the interest earned on bank savings accounts are tied to the level of the Federal Funds rate.
Meanwhile, longer-term U.S. interest rates, have moved lower this year. The bellwether 10-year Treasury note has a current yield (interest rate) of 1.6 percent. That is down sharply from 2.24 percent at the beginning of this year. (And to be clear, 2.24 percent was already anemic. Before the financial crisis the 10-year Treasury note’s interest rate was more than 4 percent.)
Unlike the Federal Funds rate, longer-term interest rates are not controlled by any central bank, but rather are a function of market demand: investors’ expectations about economic growth and inflation being key drivers. And as we are seeing in full Technicolor, the interplay of global economics is also a major driver of long-term rates.
As paltry as the payout is on U.S. bonds, it’s a lot better than the rates in many developed countries battling very sluggish economic growth. For example, the yield on 10-year government bonds in Japan, Germany, and Switzerland are below zero. The United Kingdom’s 10-year bond pays less than 1 percent.
The upshot is that the comparatively higher payouts on U.S. bonds have become popular. The way bonds work, when demand rises bond prices rise and yields fall. Thus, global investors clamoring for the higher yields of U.S. bonds have helped push the yield on the 10-year Treasury note from 2.24 percent to 1.6 percent recently. The interest rate on fixed-rate mortgages follows the path of the 10-year Treasury. The average rate on a 30-year fixed-rate mortgage has fallen from 4 percent at the beginning of the year to 3.42 percent in late July.
The latest downward movement in interest rates is just another chapter in the nearly eight-year saga of measly yields. “If you’re a saver that’s generally bad news,” says Delorme. “If you’re a borrower it’s generally good news.”
Steps You Can Take Now
Here’s how to make the most of the current low interest rate environment.
Get a Fixed Loan. While interest rates have been low since 2009, the recent sag comes at a time when household finances are in better shape. Home values have rebounded more than 30 percent and the unemployment rate is hovering near 5 percent. Moreover, lenders are more interested in doing deals than they were five years ago. “Now is a great time to lock in low fixed rates on everything from a mortgage, home equity loan, or refinancing student loan debt,” says Greg McBride, chief financial analyst for Bankrate.com.
Pay Off Variable Rate Debt. Just because rates remain low today, does not mean they will stay low forever. “Even though rates aren’t going to skyrocket higher, the smart move is to use the rate wind at your back right now to pay off your variable rate debt,” says McBride. One benefit of the continued low-rate environment is the availability of credit card balance transfer deals that charge zero interest for qualified applicants for at least a year, and in some instances as long as 21 months.
Bank on Lower Investment Returns. The extended run of low interest rates has contributed to the strong performance of stocks since 2009. But stocks values are now anything but bargains seven years into this bull market. And the bond side of your portfolio isn’t in any shape to deliver strong returns either, given today’s low yields.
“Over the next five to 10 years it is likely that stock returns will be low and bond returns really low,” says Delorme. That doesn’t mean giving up on either. Stocks provide the best opportunity for inflation beating gains over the long term, and bonds are valuable stabilizers when stocks falter.
“Focus on what you can control,” says Delorme. “Save more and spend less.”
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