Balancing Act: Interest Rates
Paul Fain, CFP®
“What are your IRAs paying?” asked my mother-in-law. Being extremely risk-adverse, and 93-years-old, she was referring to the prevailing interest rates on an IRA bank account or an IRA annuity.
However, as I politely discussed with her (as she was preparing her famous beef stew), it is important in a financial plan to differentiate between saving and investing. We save money in a checking account or a savings account to have readily available, interest-bearing, guaranteed cash for bill-paying and cash reserves for the unexpected. The interest rate credited to our savings is important but really secondary to accessibility and safety.
Investing is the process of taking higher risks to achieve higher potential returns than parking our cash in only a fixed rate account. Risk introduces the concern (fear) of losing money. Note: some investors do huddle at the extremes with all-cash/cash equivalent assets or all-stock/growth assets (in after-tax or before-tax, ex: IRA, accounts).
The wise investor finds a balance between safety and growth. Money market funds, Certificates of Deposit, and bond funds should be balanced with diverse stock funds to create conservative, moderate, or aggressive investment strategies. With retirees, we strongly advocate for allocating upcoming annual spending needs to the lower risk, lower return (aforementioned) asset categories.
So, back to Mamaw’s question with revised context, what are interest rates paying? It’s a good question, and actually one of the big themes of 2022 – rising interest rates on both saving and borrowing (debt).
Driven by economic growth and higher inflation, expect the Federal Reserve to raise benchmark interest rates two to four times this year in its attempt to push the economy back into some version of normality. Fed Chair Jerome Powell said recently he sees an economy that “functions right through these waves of COVID-19.”
Inflation will be the key variable in terms of how often and how much the Fed needs to raise rates. The personal consumption expenditure (PCE) price index, the Fed’s key inflation gauge, hit 4.7% in November, its highest since 1989.
As the Fed prepares to lift interest rates this year for the first time since 2018, here’s where borrowers and savers can expect rates on key financial products to head in the months ahead, according to Bankrate’s 2022 interest rate forecast.
Mortgage rates will climb modestly, but expect a rate ‘roller coaster.’ The 30-year fixed rate mortgage might be between 3.5% to 3.75%. Home equity loans will get costlier, expected to be about 6.25% (and the poplar HELOC at about 5.05%). Existing borrowers, however, will only be impacted if they have a variable-rate loan.
With interest rates on savings hovering near zero, savers might think they should cheer the news that rates will climb in 2022, but all signs point to a likelihood that offerings won’t be that much more attractive. Savings, money market funds, and short-term CDs may earn (+/-) 0.10%. Longer term CDs may be in the 0.50% to 1.5% range.
According to one official, “It’s going to be tough for the Fed to get inflation down to 2 percent. Even if they hike rates a few times, it doesn’t mean deposits are earning 2 percent.”
The bond market faces a familiar conundrum, as interest rates rise, bond prices fall. It is a temporary resetting of the “fixed income” marketplace. Pundits expect the bellwether 10-year Treasury bond to yield a rate of 2% to 2.5% in 2022. All things considered, there is minimal incentive to invest in longer term bonds from a yield perspective.
Yes, I know what you are thinking…my mother-in-law was also unimpressed with the family financial planning “expert’s” interest rate answer too. I think she still loves me.
The bottom line: 1) balance your investment strategy between growth and safe assets; 2) maintain a reasonable cash reserve (dry powder); 3) allocate several years of upcoming living expenses to boring, low risk bond funds; 4) invest in stock funds for long-term inflation protection and for future spending needs (say 5+ years from now). And lastly, 5) expect every one of these forecasts to be wrong! Adjust your financial plan as needed – call the APC Team for review and updates.