What Do Rising Interest Rates Mean for You?
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Rising interest rates will have a potential impact on investing, borrowing, wealth management, estate planning, and taxes. There are challenges and opportunities ahead.
No one enjoys digging deeper into their wallet to fill up the gas tank and put food on the dinner table. No one cheers as they watch gains in a retirement account get wiped out in a day of volatile trading in the stock market. But that is what we have endured for several months, a principal factor being the economic uncertainty caused by rising inflation.
For almost a decade, the inflation rate remained below 3%, dipping as low as under 1%. While low inflation depressed wages and economic growth to some extent, it also kept the cost of goods, services, and borrowing money stable. In turn, stable borrowing costs made it easier for companies and consumers to plan investments and purchases into the future.
But with inflation rising in June to a 40-year high of 9.1% year-over-year, the stable landscape is changing. Goods and services are more expensive and borrowing costs are higher. Still, an inflationary economy presents opportunities for making money and preserving wealth, as long as inflation does not spiral out of control and lead to recession.
To keep inflation in check, the Federal Reserve Board (the Fed), which manages the nation’s monetary policy, has raised the federal funds rate several times in the past few months. The federal funds rate is the rate Fed members charge each other for overnight loans. That rate, in turn, influences the prime rate, which is what banks charge their most creditworthy customers, and indirectly affects the rates on mortgages, savings and loans.
As the Fed has signaled it will raise rates several more times through the end of 2023, here are some steps to consider:
Portfolio Allocation: Maintain a diversified mix of stocks, bonds and other investments — consistent with your goals and risk objectives.
Stocks: Even though markets may remain volatile until inflation comes down, stocks provide the best opportunity to outpace inflation over longer periods of time. Favor companies with high-quality earnings.
Bonds: Stick with short- and intermediate-term bonds to reduce duration (interest rate risk) resulting from the Fed’s monetary policy of raising interest rates (as discussed earlier). Also consider inflation-indexed bonds, which are tied to the Consumer Price Index, a common measure of inflation.
Certificates of deposit: Consider moving some cash into higher yielding, short-term CD accounts. The interest paid on CDs usually lags the inflation rate, but should inch up from the low levels of the past decade and remain attractive to those who desire stability. Remember not to cash them in early, or you may incur a penalty; also consider a CD ladder over multiple maturities to reinvest at higher rates.
Real estate and commodities: Property values and rental income tend to keep pace with inflation over time. Gold, raw materials, and infrastructure investments have historically provided a reasonable portfolio hedge during periods of inflation.
By historic standards, money is still cheap. Over the past 50 years, there have only been a few times during which the real interest rate (the nominal interest rate less the rate of inflation) paid by a borrower has been negative, and it did not stay that way very long. Moreover, the real negative rate never got above a single point.
Today consumers can borrow at negative rates much lower than a single point. For example, the CPI historically runs below the 30-year fixed mortgage and the prime rate. But as of this past May, the Wall Street Journal prime rate was 3.5%, the 30-year mortgage rate average was 5.1% and the CPI was 8.5%.
So for borrowers, now could be a good time to examine your floating and adjustable-rate debt to see if it makes sense to lock in a fixed rate, particularly if your loan is due to reset in the near term. If you choose to refinance a mortgage, make sure you factor in any points charged by the lender and other up-front closing costs.
Some borrowers also may want to consider an interest-rate swap, which involves the exchange of a fixed rate for a floating rate via the purchase of a derivative to either reduce or increase exposure to fluctuations, or to obtain a lower rate. These exchanges should only be entered into by sophisticated clients and we recommend soliciting advice from your advisor.
For Estate Planning, Wealth Management, and Taxes
Rising interest rates can affect some estate planning strategies for minimizing taxes and preserving assets.
Each month, the Internal Revenue Service publishes short-, mid- and long-term rates (Applicable Federal Rates (AFRs)) and the §7520 rate. The AFRs reflect the minimum interest rate that must be charged for loans between related parties to avoid triggering imputed income or gift taxes. The §7520 rate, named after a section of the tax code, is 120% of the mid-term AFR, and is used to calculate annual payments for certain estate planning techniques. It is often referred to as the “hurdle rate” because certain strategies depend on investments returning more than the current §7520 rate to be successful.
As interest rates increase, so do the AFR and §7520 rates. Generally, the rate that applies to a specific planning strategy is the rate in effect at the time the strategy is initiated. As rates rise, the effectiveness of specific planning approaches changes. Some planning strategies are more favorable in a low-interest rate climate, while others are more beneficial in a rising rate or higher rate environment.
Check with your advisor to help plan how the following tax strategies can enhance your overall financial plan:
Low-interest rate environment strategies
Intra-family loans, Grantor Retained Annuity Trusts (GRATs), sales to Intentionally Defective Grantor Trusts (IDGTs), and Charitable Lead Annuity Trusts (CLATs) generally prove more effective in low-interest rate environments. If you believe interest rates are going to continue to rise, now might be an opportune time to fund them.
High-interest rate environment strategies
Charitable Remainder Annuity Trusts (CRATs) and Qualified Personal Residence Trusts (QPRTs) often work better in a high-interest environment. Consult your advisor to decide whether to lock in now or take advantage of potentially higher rates in the future.
There are both opportunities and challenges during periods of inflation.
Investors should review their portfolios to make sure they remain consistent with long-term goals. Best bets include:
- The stocks of established companies with a stable history of earnings
- Short-term and inflation-indexed bonds
- Short-term certificates of deposit
Borrowing costs remain historically low but likely will rise additionally in the next year. To hedge against future increases, consider locking in fixed rates on adjustable and floating interest debt that will reset soon.
Preserving wealth will require deft management and skillful timing. Certain strategies do well when rates are low while others perform best when rates are high, and tax implications can influence those outcomes.
For more information, please contact your advisor.
About Tina A. Myers
As the Director of Financial Planning for Key Private Bank, Tina is responsible for managing the Central Planning Team, as well as overseeing the National Advisory Committee, Monthly National Advisory Call and any financial planning literature developed internally and externally. She works with our Regional Directors of Planning to help facilitate our best thinking and advice delivery to clients.
Tina earned a B.S. in Bus. Admin. from the Univ. of Richmond and an M.Tax from Virginia Commonwealth Univ. She is a CFP® certificant, CPA/PFS, and is an AEP®. She is Treasurer of the Put-in-Bay Community Swim & Sail Program. Tina received the 2016 Exceptional Service Award from the Cleveland Estate Planning Council and the Circle of Excellence Award by Key Private Bank in 2016 and 2018.
About Jim Thomas
Jim Thomas is the National Head of Banking for Key Private Bank. He and his team support clients throughout the country by assisting in appropriately structuring and leveraging credit transactions within the context of a plan that benefits all of the client’s long-term objectives. He joined Key in 2007, initially as a relationship manager in business banking. Prior to that, he served for many years in retail and commercial banking with another lending institution. A Baltimore native, he earned a Bachelor of Business Administration from James Madison University and an MBA, with a concentration in finance, from Xavier University. He and his family currently reside in Fort Myers, Florida. Jim serves on the advisory council of the Harry Chapin Food Bank, which annually distributes more than 12 million pounds of food to needy recipients in southwest Florida. He is a past Executive Board member of the Southwest Florida Council of the Boy Scouts of America, and is the former district chairman of the Boy Scouts’ Seminole District in Southwest Florida.