Whether you are looking to borrow money or invest it, a sense of the current interest rate environment can be helpful. Interest rates can be thought of as the cost of borrowing money or the return on investments for lending money, and they play a critical role in regulating the economy.
Beginning in the spring of 2022, interest rates regained a lot of attention. It was about this time that the federal reserve began aggressively raising interest rates. Prior to that time and dating back to the end of the Great Recession in 2009, interest rates had been held very low. So, why did interest rates rise so rapidly and how has the increase affected the economy?
As to the why, that goes back to the role interest rates play in regulating the economy. In the aftermath of the financial crisis, the economy had slowed sharply and fell into a deep recession. Policy makers wanted to stimulate demand in the economy, so interest rates were lowered and held low to promote borrowing and consumption. Then COVID struck and there was a rapid increase in demand for all types of products because we were stuck at home. That, coupled with supply chain disruptions among other factors, led to a rapidly accelerating economy and inflation. Now policymakers wanted to suppress demand and slow the economy to get a handle on inflation and, in response, they began to raise interest rates.
How do interest rate changes influence the economy? When interest rates are low, consumers and businesses are more likely to borrow money to make purchases they might not otherwise. This borrowing might be to buy a new car or fund business expansion. This activity in the aggregate across the entire economy propels expansion. Alternatively, when interest rates are high, those same consumers and businesses will think twice about a purchase because it effectively costs more. These second thoughts lead to delayed and maybe even no purchase and cause the economy to slow.
How might the current interest rate environment impact financial decisions? Perhaps the biggest decision many people face is whether to buy a home. Making that decision has been made more challenging given today’s interest rates.
Interest rates will eventually begin to drop and when that happens, those that took out a mortgage with a high rate are likely to refinance. Because that original mortgage is not likely to be held very long, not many buyers are paying discount points. Mortgage discount points are typically paid to lower the loan's interest rate by .25%, so one point would lower a mortgage rate of 7.5% to 7.25% for the life of the loan. For example, on a $500,000 loan a borrower would pay $5,000 to buy one point. Depending on how long you keep the loan, you and your loan officer can determine if it makes sense to buy down your interest rate. It is a very individual decision.
For small business, the Truckee North Tahoe region is home to many resources. The decision to start or expand a business is not an easy one and business owners often borrow to make their dreams a reality. In Truckee, we are fortunate to have a small business development center at the Sierra Business Council.
According to Jessica Carr, director of the Sierra SBDC, said, “for small business lending, the increased borrowing cost and rate variability of many loan products places a high burden on a business’ cash flow. This translates to less money available to reinvest in the business, and higher prices paid by the consumer. Clients with variable rate loans have seen their payments jump. New SBA 7A loans have had rates increase from 6.5% to 11.25% in just 18 months.”
One bright spot for business owners as we wait for interest rates to drop, financing for commercial property purchases are relatively affordable providing an opportunity to acquire business real estate without competing with investors that are waiting for rates to drop.
There’s no denying that borrowing money today is going to cost more. On the flip side, savers have been rewarded with interest rates not seen in many years. Short-term treasury bills, debt issued by the U.S. Government, are paying more than 5%. For longer term investors, have recently become much more interesting. This is because the price of bonds moves opposite of interest rates. I believe 2022 brought the worst of the interest rates increases. Although nobody knows for sure, I believe the next move for interest rates is more likely to be a drop rather than another rise. If this happens, those boring bonds are likely to appreciate.
What goes up, must come down. It is not a matter of if interest rates will drop, just a matter of when. When that does happen, the cost of borrowing will go down. That loan taken to buy a house or fund a business can be refinanced for a lower rate. Those bonds in your investment portfolio are likely to be worth more. If you are facing an important financial decision that requires borrowing or investing, although very important, interest rates should be only one of many factors influencing your decision. Don’t let the interest rate tail wag the decision dog.
This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Please consult your financial advisor prior to making financial decisions.
The financial professionals of Pacific Crest Wealth Planning are Investment Adviser Representatives with/and offer advisory services through Commonwealth Financial Network®, a Registered Investment Adviser. This communication is strictly intended for individuals residing in the United States.
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