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Consumer spending represents two-thirds of economic activity: It's the dynamo that powers this country's economic engine. When the Fed raises interest rates, hoping to head off inflation, consumers think twice about spending. They hesitate to buy a home, because mortgage rates go up. They hesitate to buy a car, because auto loans are more expensive. They hesitate to pull out their plastic for anything beyond the basic necessities, because the high interest on credit card debt goes even higher. Big business gets hit in the same way, since companies need to borrow money too. The final complication: Higher interest rates usually mean lower returns on stocks and mutual funds, as investors sell their holdings in anticipation of lower corporate profits.
So rising rates roil the waters for everyone. But they're not an automatic reason to worry. By taking precautions now, you can glide through the turbulence without upsetting your financial boat. One way to lessen the impact is to re-examine your outstanding loans. For most Americans, their most valuable possession is their home. If you haven't refinanced your home mortgage in the past few years, do so now. You won't get the historic low rates, but the odds are good they'll be moving even higher soon -- and it's unlikely that you'll see such easy money for perhaps years to come.
As you refinance, think about how long you will live in your house. Typically, people stay put for six to seven years. If that describes you, think about getting an adjustable-rate mortgage, where the rate is fixed at today's lower levels for a period, then adjusts to the prevailing rate. These mortgages come with fixed terms from 3 years to 7 years or more. Shop for the one that fits your timetable.
If you're carrying any credit card debt, unload it now. A new home mortgage may help here. If you've been in your house long enough to build equity, you can increase the size of your mortgage up to 90% of the value of your house and use the cash to pay your bills.
Another way to borrow money cheaply is through a home equity line of credit. Its interest is tied to short-term rates, which are still under 5%. You'll pay much less for borrowing than you would on your Visa or MasterCard. "A home equity loan works like a mortgage, but the difference is that it's a line of credit, not an out-and-out loan," says Ed Yardeni, chief economist and strategist at Prudential Financial. "The borrower decides when he or she needs the money and writes a check against the equity up to the amount of credit allowed by the loan."
Another bonus: The interest you pay on a home equity line is generally tax-deductible.
Rising rates pack a one-two punch: The increased cost of borrowing money is followed by a hit to your savings strategy. So how do you protect your nest egg?
When rates move higher, people sell stocks. They speculate that putting the brakes on the economy will lead to a slowdown in corporate earnings. More important, higher rates create investment opportunities other than stocks. After all, the thinking goes, why should I risk owning equities when I can buy rock-solid U.S. Treasury bonds once higher rates produce a competitive yield?
Bonds that you buy today will be worth less in the future, because as yields move higher, bond prices move lower. If you can't wait to buy bonds, experts say the best idea is to "stay short," meaning buy short-term bond funds and money market accounts. Short-term CDs, which have been posting returns of around 1% for the past several years, are perking up, at least a bit. As the rates go up, you can look for opportunities to invest in longer-term bonds or bond funds delivering higher yields.
Certainly, you need to re-examine your IRA or 401(k) in light of the interest moves. Most money managers will tell you to lighten up on fixed-income funds, which move down in price as rates go up. Instead, you might look at investing in companies that pay a dividend. That way, no matter how the stock price moves, you'll probably still get a payment every three months. Utilities, financial services companies and tobacco companies have traditionally paid dividends yielding 3 to 5%. Software giant Microsoft just raised its dividend, and other high-tech companies may follow suit.
You can also get income in your retirement accounts from stable-value funds, which carry a yield much higher than CDs and money-market funds. These funds outpaced money-market funds by more than 2 percentage points over the past five years.
Of course, with interest rates up and market returns down, one of the surest ways to protect yourself is to save more, even if it means scrimping. If you're a truly conservative investor and have substantial money in savings accounts, you are about to see a better return than you have in years.
Rising interest rates can be a shock, but they don't have to shock your wallet. Even the most powerful man in the world would agree with that.
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