How to Benefit from Rising Interest Rates

By Wendy Connick Markets Fool.com

The past several years have seen historically low interest rates and near-zero inflation, but the economy has finally started to rev up again, and interest rates are climbing toward more normal levels. That's great news for savers, but not so good for borrowers -- especially if you're carrying adjustable-interest debt such as a credit card balance.

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No one has a crystal ball that can say where interest rates will go next, but all signs indicate that we can expect them to climb gradually upward -- and they can hardly go down from their current levels. So if you want to position yourself to benefit from rising interest rates, then consider taking the steps below.

Reduce your debt

Long periods of low interest rates are terrific news for debtors, who can borrow money at almost no cost. When I bought my house a few years back, I was able to get a 30 year mortgage with a 3.25% interest rate -- an unbelievably low rate compared to mortgage benchmarks from the past. However, with rates on the climb, even borrowers with terrific credit won't be able to get anywhere near that good a deal. Today, the benchmark for 30-year mortgage rates is 4.24% --nearly a full percentage point more than what I paid -- and interest rates are likely to continue their upward trend for the foreseeable future.

Rising interest rates are particularly brutal for holders of credit card debt, since credit card interest rates are both adjustable (meaning that the interest rate on your existing balances will rise as overall rates rise) and extremely high. Thus getting rid of credit card debt is a top financial priority during times of rising interest rates. If you can't clear out that debt right away, consider getting a fixed-rate loan and using it to pay off your credit cards, thereby locking in a relatively low rate on your debt. Another option is to look for balance transfer cards, which give you several interest-free months to pay down the amount you transfer to the new card.

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Compare savings accounts

The interest paid on traditional bank savings accounts has been minuscule for several years, but as interest rates rise overall, savings rates should climb as well. However, some banks will respond more quickly than others to the new rate environment, so a little price-shopping could yield you an account with a far better return. Consider putting most or all of your savings in an Internet-only bank; because they don't need to pay the expenses involved with owning brick-and-mortar branches, online-only banks can usually offer customers a substantially higher rate of interest.

Get help with saving

If you have a hard time finding enough room in your budget to save on a regular basis, consider signing up for an automatic saving program. Nearly all banks will allow you to set up an automatic transfer between your checking and savings accounts that makes saving a set-and-forget proposition. You can also look beyond your bank's offerings to find a saving routine that may suit you better. For example, there are several free savings apps that use algorithms and other high-tech tricks to help you save. Digit, which has almost a cult following among its users, analyzes your checking account history and calculates how much money you can spare. Then, every few days, it transfers that money into a special savings account. The company is confident enough in its algorithm to offer a no-overdraft guarantee. Daily Budget Original, an Apple-only app, goes a step further and builds an entire budget for you based around your expenses and savings goals. It also includes an automatic saving feature. Other, similar apps abound; a little searching will likely identify one that's a good fit for your preferences.

Investments that profit from rising rates

When interest rates start to climb, bonds and bond funds will decline in value, which can be a big problem for retirees and other income-centric investors. After all, why would someone buy a bond from you that returns 2% when they could instead buy a newly issued bond that yields 4%? The solution is to focus your bond investments in short-term bonds; they suffer less from rising interest rate trends, and as they mature you can replace them with bonds reflecting the now-higher interest rates in their returns.

A somewhat riskier strategy calls for investing in variable-rate securities, typically in the form of either floating-rate bank loans or corporate securities. Because yields on these securities rise along with interest rates, they can be a great choice in a rising-rate environment. However, if rates take a nosedive, so will the yields on the securities. Also, floating-rate securities are generally issued by troubled companies, so there's a significant default risk. It's best to buy these securities in moderation, not use them as a linchpin of your portfolio.

Climbing interest rates can have a mixed effect on the stock market. On the one hand, moderate interest rate increases typically go hand in hand with moderate inflation, which is great for businesses and therefore has a positive effect on the stock market. On the other hand, higher interest rates make debt more expensive for businesses and for individuals, so businesses with a lot of debt will be spending more to cover it and may struggle to keep their profits up as a result. One sector that tends to benefit quite a bit from rising interest rates is the financial sector: Banks and other lenders thrive in such an economic environment. In other sectors, companies and industries with high assets and low liabilities would also be likely to do well during times of moderate interest rate increases.

Don't abandon your investing strategy

Just because interest rates are starting to go up doesn't mean you should retool your entire portfolio. After all, there's no way to be sure what will happen in the months and years to come. It makes more sense to tweak your investments a little at a time to meet changing circumstances. If rates continue to rise, you can continue to shift more and more of your portfolio over to investments that benefit in such economic conditions. That way, if interest rates do a 180 on you without warning, you won't have bet more than you can afford on their continued rise.

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