As the Federal Reserve lifts interest rates up from their historically low levels, you're likely to start seeing the effects on your financial holdings. It's important to understand how these changes will affect different types of accounts and investments in order to be prepared for the results.
Stocks and rising interest rates
Rising interest rates tend to have a mixed effect on stocks. On the one hand, as interest rates go up it becomes more expensive for companies to borrow money. They may be forced to tighten their belts a bit, causing profits (and stock prices) to droop. And when debt becomes more expensive, consumers may be forced to cut back on their spending; that can also cause a drop in profits and therefore a drop in stock value.
On the other hand, companies that lend money rather than borrow it (banks, mortgage lenders, insurance companies, and so on) may have their profits and stock prices climb during an interest rate hike because they can pass the increased costs along to their customers in the form of higher interest rates. Thus, stocks in the financial sector tend to benefit as rates move higher.
Whether a particular stock is a growth or value stock could also affect how it reacts to interest rate shifts. Companies that are considered to have value stocks tend to have strong cash flows and a stable financial base; thus, rising interest rates don't affect them as much as they do the average company. Companies that are considered to have growth stocks, meanwhile, typically have a less abundant cash flow and lots of debt, so rising interest rates have a bigger-than-average impact on them.
Bonds and rising interest rates
Like stocks, bonds react differently to interest rates depending on the situation. An increase in interest rates will reduce the value of the bonds you already own, because those bonds are now paying less in interest than bonds issued after the increase. However, newly issued bonds become more valuable because these bonds pay higher interest in response to the overall increase in rates.
Investors whose primary goal is to generate income from investments usually get a positive long-term result from rising interest rates, because higher rates mean higher income. Such investors can lessen the impact of such a rise on their existing bond issues by bond laddering. With this approach, bond purchases are spread out over a long period of time, which also spreads out the impact of interest rate changes. Older bonds that were issued during periods of low interest are regularly rotated out and replaced by new issues with higher interest payments.
Other assets and rising interest rates
As a rule of thumb, rising interest rates are good for lenders and bad for borrowers. For example, as interest rates go up so will the interest charged on your credit cards (which means using those cards will be even more expensive for you). And while existing fixed-rate debt, such as most mortgages, won't change in response to interest rate increases, if you try to get a new mortgage or refinance your mortgage you'll be charged a higher rate on the new loan.
The good news is that bank accounts, such as your checking and savings accounts, will raise their interest payouts as the overall interest rate climbs. When interest goes up, inflation generally does as well, so physical assets such as your home will become more valuable as a result. The bottom line: a change to interest rates will impact your finances in many different ways, so be prepared to see some interesting activity on your various accounts if the Fed hikes rates again.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.