Inflation & Rising Interest Rates
Both borrowers and savers will be impacted; what steps should they take in this environment?
Inflation continues to hit historic highs and the Federal Reserve has moved up its plans to wind down their bond-buying stimulus program and start lifting short-term rates. Both borrowers and savers will be impacted and should consider the following when planning how to best navigate an inflationary environment with rising interest rates.
For those of you managing a portfolio of debt, the combination of rising rates and inflation can be a contradiction.
Inflation can benefit borrowers because it reduces the real value of your debts. (A mortgage of $400,000 two years ago is worth less than today because inflation has reduced the purchasing power of that $400,000.) However, rising rates can negatively impact borrowers with variable loans or looking to refinance high-interest debt.
What borrowers should do with rising interest rates on the horizon:
Pay off or refinance variable debt into fixed rate loans. As interest rates rise, so will the cost of borrowing money. Variable interest rates will begin increasing, making your payments unpredictable and higher. If you cannot pay off your variable loans, refinance them into fixed rates to avoid unpredictable increases.
Lock in your Home Equity Line of Credit (HELOC). If you have a line of credit on your home and your lender allows rate locks, consider taking advantage and locking in some or all of your outstanding balance.
Consolidate your HELOC with your mortgage through a refinance. While we are still in a lower interest rate environment, consider consolidating your debts at a fixed rate.
Bottom line, before an interest rate rise occurs that could negatively impact your short-term cash flow or long-term financial outcomes, make a plan to lock-in or pay off any variable debt.
Like borrowers, saving monies in this environment of rising rates and inflation is a dichotomy.
Inflation punishes savers because any money you have in cash deposits loses its value during inflationary periods. However, rising rates can positively impact savers as rising rates will mean banks and other financial institutions will increase the amounts of interest they pay on deposits.
What savers should do in an environment of rising interest rates and inflation:
As interest rates rise, shop for the best rates available. It will be important to park any cash in accounts paying competitive interest rates to combat the incursion that inflation is having on your cash deposits.
Consider reallocating a portion of your cash to other asset classes. An excess of cash on the sidelines during inflation will negatively impact your financial outcomes. Evaluate your immediate and emergency cash needs and consider reallocating any excess cash into assets that historically hedge inflation, such as equities or real estate.
Continue saving, but be selective where you save your funds. Some bad advice in the news media is to spend your cashflow in lieu of saving it because inflation will decrease the value of any cash sitting on the sidelines. This is penny wise, pound foolish. If you already have a sufficient emergency fund and cash reserves for immediate needs, consider saving your money into a portfolio of equities and other asset classes that historically hedge inflation.
Bottom line, while interest rate increases may benefit savers and the cash they have on the sidelines, savers should plan to reallocate any excess cash or savings towards asset classes that historically hedge inflation such as equities.