As humans, we instinctively pay close attention to things that excite us and ignore those that bore us. As investors, we must fight this instinct with every fiber of our being as the boring topics are often the most important to long term financial success. While most financial news is centered around the day-to-day movements of stocks and bonds, interest rates are only briefly mentioned in most broadcasts, and then it is “back to the stocks”! While this mentality is normal, and perhaps good business for the financial media, it leaves many people uninformed about an important aspect of their financial lives. Currently, interest rates are on the rise, and while this may be good news for lenders (i.e. banking institutions issuing new debt), it is bad news for borrowers (i.e. young families looking to buy their first home). Considering the lack of focus in this area, I asked my Partner and Senior Advisor, Marshall Clay, JD, CFP® to give us direction on how to navigate this rising interest rate environment from both a borrower and lender perspective. Below are his thoughts!
- Develop a Plan to Pay Down Existing Debt
A wise man once said, “Be your money’s master, and not its slave.” For those with existing debt obligations, you are somewhat in the “slave category.” The following is a step by step approach to flip the script and become your money’s master:
Step #1: Identify the debt obligations with variable rates, meaning the interest rates can fluctuate and are not fixed (Examples: Adjustable Rate Mortgages, Home Equity Lines of Credit, and Credit Cards). If possible, look to transition these obligations to fixed rate loans.
Step #2: Identify the minimum payments required across all debt obligations to prevent late-payment penalties from adding to interest you are already being charged.
Step #3: Rank the debt by interest rates in order of highest to lowest.
Step #4: After satisfying the obligations in Step #2 above, pay down the highest-ranking (or highest interest rate) debt on your list, usually credit cards, until it is fully paid off.
Step #5: Repeat this process until all debts are fully paid. Remember, do not get discouraged as you will be surprised how fast you can pay down debt with just a little planning and discipline!
- Avoid Accumulating New Debt
Staying away from debt completely is always sound advice, but in today’s world it is unavoidable for most. While not all debt is bad (i.e. Business Loans, Home Mortgages), certain types of debt, such as credit card debt, are toxic and should be avoided at all cost unless being paid in full on a month-to-month basis. This advice is especially relevant during a rising interest rate environment, as new debt will cost much more! Do not be surprised to see your credit card companies increasing their rates within the next 12 months, if they have not already done so.
For Lenders/Investors in Bonds:
- Understand your Portfolio’s Allocation to Bonds
When investing in bonds, or fixed income, the key is to understand who you are lending to, and what time period the borrowers must pay back the principal you lent them. Interest rates have an inverse relationship to bond values, so as interest rates rise, bond values fall. If looking to avoid the risks associated with bonds in this rising interest rate environment, it may make sense to adjust your bond portfolio to bonds with higher credit quality, meaning there is less risk of the borrowers defaulting on the debt, and shortening the amount of time in which those borrowers must pay back the principal (this is what investment managers refer to as “duration”). While you will likely sacrifice potential yield/cash flow with this strategy, it will reduce the risk of default, and perhaps give you flexibility to reinvest in higher yielding bonds later.
- Understand Your Short-Term Cash Flow Need
If you are someone who needs, or may need, cash flow in the short term (within 12-24 months), look to short term CD’s and Money Market Funds to avoid the potential price fluctuations associated with bonds in this environment. The key in any market is to avoid being forced to sell assets when they are temporarily down in value to address a cash flow need. When investing in these short-term investments, the intent is to place your money in a safe spot, where it can be called upon to meet your cash flow with very low risk of depressed values. So, if you know you need money for things such as monthly expenses, college expenses, trips, new cars etc., these vehicles may be a good place to position your capital.
Thanks Marshall! Today’s interest rate environment certainly has its challenges but considering the advice above will help you take control of your debt and not let it control you!