Best Navigate The High Interest Rate Environment
As the Federal Reserve keeps raising rates many of us are wondering how we should best deal with the rising interest rates. Within a matter of months, the mortgage rates have doubled, and borrowed money in general has gotten significantly more expensive. But for financially savvy individuals like yourself, you see opportunities when others see fear. You know there are smart ways to navigate the high-interest rate environment, so you come out better and stronger and the other end.
If you are in your 20 or even 30s, you grew up in a low-rate environment pretty much your whole life. So you might be shocked by the cumulative effect of the Federal Reserve’s monthslong campaign to stamp out inflation with higher interest rates. If you’ve been in the market for a new home, you might feel like throwing in the towel. If you have credit card debt you might really be feeling the squeeze. And if you have money invested in the market, you might feel the temptation to do something - like sell.
However fear not, there are ways to navigate this high-interest rate environment and come out even better off than before. In this post let me share with you five strategies to best navigate the high-interest rate environment:
Rise of Interest Rates & The Market
But before we get into the specific strategies to navigate the high-interest rate environment let’s talk about how we got here in the first place, and what effects it has on the general economy.
When we hear about the rising interest rates, the first question that many of us ask is this. Why is this happening? Or why is the Fed raising rates? Just because they are bored? No, of course not. Or I genuinely hope not.
The Federal Reserve, the nation’s central bank’s key role in the government, is to keep the economy stable for the American people. Its job is to keep inflation in check and help the job market grow as much as possible. Therefore when the inflation is as high as it is right now, it uses interest rate as a mechanism to control inflation. This past year we have seen prices rise sharply for a variety of goods and services as strong demand collided with persistent supply shortages. Some highly consumed items like meat and bread became 10% or even 20% more expensive.
The Fed raises or lowers its benchmark rate, known as the federal funds rate and this influences how much banks and other financial institutions pay to borrow. Which in turn influences how much businesses and households can borrow.
In general lower rates help stimulate the economy by making it cheaper for businesses and households to borrow money. The Fed did this following the housing crisis in 2007 and 2008. It did it again in 2020 during the Covid-19 pandemic to a record level of nearly 0%.
Higher rates do the opposite and are designed to slow the economy by dampening consumer demand, and in turn, ideally, help to curb inflation; less demand, lowers the price. The Fed hiked the rates from 2005 to 2006 to cool off the economy and the growing real estate bubble.
Now the jury is still out on how well the current raising of inflation will bring down inflation, but nonetheless, it seems to have made an impact on the current stock market and the general economy as a whole.
Since the beginning of 2022, the Total Stock Market is down 18% and the S&P 500 is down 20% from the same time last year. However as history and general market economics have shown, this is a normal byproduct; higher rates typically cause market dysfunction. This is partially by design. High-interest rates are designed to slow the economy down.
Borrowing becomes more expensive. Companies take out fewer loans to create new products and consumers spend less on buying these new products. Especially those that require financing. Alright, with that said let’s talk about five strategies to best navigate the new high-interest rate environment.
01 - Destroy High-Interest Debt
I know, it's not an exciting strategy but there is a reason I want to kick off with this one. In a high-interest environment, you have to treat high-interest debt like a fire on your house. You have to prioritize taking that fire out because once it starts engulfing another part of the home, it gets extremely hard to get out from under high-interest consumer debt.
According to the Federal Reserve Bank of New York, the total credit card balance in the United States hit close to a trillion dollars ($890 billion) and student loans hit close to $1.6 trillion dollars ($1.59 trillion) as of the 2nd quarter of 2022. Both record high numbers. For credit cards where the interest rates vary, higher interest rates drive higher annual percentage rates, or APRs, making it even more costly to carry debt.
According to Bankrate, the average APR on credit cards reached 18.73% in October, up from 17.35% at the start of 2020. The average credit-card balance is $5,221. If someone only makes the minimum monthly payments on their average credit balance, it would take them an extra three months to pay off that debt.
I don’t know about you, but these numbers terrify me. And in a high-interest-rate environment, it should terrify you as well if you have high-interest debt that you’ve been carrying month to month.
If you don’t get it under control, it won’t matter what else you are doing with your finances, this fire can and will consume other parts of your financial home. So before you do anything, tackle and destroy high-interest debt. There is no easy way to knock down high-interest debt except to just do it.
List out all your high-interest debts and create a plan for getting rid of them. You can use the debt snowball method or the Avalanche method. Whichever one can best motivate you.
You want to minimize risk, and one sure way to minimize risk in a high-interest rate environment is to get rid of high-interest debt that will be directly impacted by the high-interest rates.
02 - Earn More From Your Cash
Now if you’ve consumed any of my other content, you know I love holding cash. They don’t provide great returns, but they pay in multiple other ways. Not only does cash allow you to buy opportunities and ride out uncertainties, but it gives you most importantly mental and emotional peace. Allowing you to make the best financial decision without being rushed and pressured by the lack of liquidity.
Now for the past decade, it was almost impossible to earn more than 0.01% interest on your cash given how low the interest rates were. However, during times of high-interest rates, you can find places where your cash can earn a higher interest rate. Almost like having your cake and eating it too.
Yes, banks have been slow to raise rates on standard savings accounts, but the general rule of thumb is that Fed rate increases should lead to higher returns on savings. If you shop around, there are currently high-yield options available. Start with your current bank and make sure to ask around.
If you are willing to move your money because you aren’t too tied to your current bank, banks like Capital One and Goldman Sachs’s Marcus are offering 3.0% in annual percentage yield. A year ago you would have been hard-pressed to find an account with even one-tenth that in interest so a 3.0% interest rate on your cash is a refreshing silver lining in a high-interest rate environment.
03 - Rethink House Purchase
This one is a hard one to swallow if you’ve been in the market for a new home. But when interest rates rise, one of the biggest categories of borrowing that it impacts is the mortgage market. Changes in mortgage rates ultimately affect homeowners’ monthly payments.
When you run the numbers between different interest rates you will notice that higher mortgage rates can add hundreds, if not even thousands of dollars to monthly payments. And it doesn’t help that starter homes are harder to find across the country.
According to Freddie Mac, in October 2022, mortgage rates topped 7% for the first time in two decades. This is more than double the 3% rate many Americans could get on a 30-year fixed-rate mortgage a year ago.
A $400,000 mortgage at a 3%, 30-year fixed rate mortgage would have had a $1,686 monthly mortgage payment. Today the same mortgage at a 7% interest rate would cost you $1,000 more, a $2,661 monthly mortgage payment. And that is just the payment, when we compare the total interest paid for the duration of the loan, the impact is even more sobering. For a 3% mortgage, you would have paid a total of $207,110 in interest. In today’s interest rate environment, at a 7% mortgage, you would pay a total of $558,036 in interest. A difference of more than $300,000, just in interest. Talk about compounding working against you right?
Think hard about a home purchase right now. Delaying the homeownership process can hurt at first but it may give you additional time to save for a bigger down payment. And there is a chance home prices could also drop in the meantime. Of course, no one knows for sure, but a way to best navigate through a high-interest rate environment is to minimize risks in your life. We just don’t know how much higher interest rates will go and when they will turn around again.
If you are really stretching your budget to make the 7% interest rate mortgage work in your finances, it may be time to step back a little and rethink that purchase.
04 - Maximize Credit Score
You and I can’t do much about the Fed. If they want to raise the interest rate, so be it. We can complain all day long about how unfair it is, but that is the reality of living in today’s world.
However, there are still things that are in our control that can have an impact on our ability to borrow at the best rate and that is our credit score. Outside the Fed, personal credit score has the greatest impact on a consumer’s ability to borrow money at the best current rate.
Financial companies save the best rate for their ‘safest’ and ‘best’ borrowers because they know based on statistics these borrowers will pay back money borrowed, on time and in full. And a good to excellent credit score is the best indicator to identify who these ‘safest’ and ‘best’ borrowers are.
And improving your credit score doesn’t just impact the interest you pay on your credit card debt if you are looking to pay off high-interest loans. It saves you throughout all aspects of borrowing including auto loans, student loans, and mortgages.
To have the best credit score possible, I recommend concentrating on these two factors. Making all your debt payments on time and keeping your credit utilization ratio as low as possible. These two factors have the biggest influence on how your rating is calculated. A strategy I like to use to keep my credit utilization ratio low is to call up the credit card company and request an increase in my credit limit. If you have a history of making your payments on time and have an excellent credit score, this should be an easy request for the credit card company.
And just a note. Just because you have an excellent credit score doesn’t mean you have permission to go out and borrow more money. Remember, this is a high-interest-rate environment so you want to be very cautious about taking on more debt. You want to maintain your excellent credit score in case you want to borrow in the future, but also to prevent yourself from getting into more high-interest debt. And if you do have to borrow, it’s best practice to shop around for the lowest rate possible and never spend more than you can afford to pay back.
05 - Ignore Market Volatility
So far we talked mostly about defense strategies. Reducing debt, maximizing credit scores, and rethinking home purchases. However, we don’t want to just survive through a high-interest rate environment. We want to come out the other end stronger and better. And a sure way to do that is to see the opportunity when everyone else is scared.
As I mentioned earlier when the Fed raises interest rates this in turn raises borrowing costs. And when borrowing costs go up, it has a ripple effect of tapering growth and consequently fueling market volatility as businesses and consumers try to navigate the market uncertainty.
We don’t have to look far to see this. As I mentioned earlier in the article, since the beginning of 2022, the Total Stock Market is down 18% and the S&P 500 is down 20% from the same time last year. But if you are a long-term buy-and-hold investor, this shouldn’t mean anything. You have decades ahead and want to constantly invest more as you go. These market dips are just a blip in your long-term investing journey. Just take a look at a chart of the S&P 500 in the last 100 years.
S&P 500 - Last 100 Years
We’ve had similar rising interest rate environments in the past. But if you have confidence in the American economy, the trend is and will be up. So you will recognize the 20% drop in the market as the “stocks on sale” buying opportunities because you are a savvy, smart investor. Use the market uncertainty created by the high-interest rate environment to your advantage and just keep buying.
Conclusion
The ultimate goal with rate hikes is to give the economy a soft landing — slowing inflation, but not too much that it tips the economy into a recession. But that is a tall order, even for the US central bankers. Let’s hope that it doesn’t get any worse than it is right now, but that doesn’t mean we idly sit by as spectators. There are strategies we can implement to safeguard our finances as well as take advantage of opportunities.
