What to do as interest rates rise: following these investment tips can help you keep pace with inflationary pressure.
Webb's father, Reggie, a 56-year-old McDonald's franchisee who owns 11 restaurants in Southern California with another soon to open, is planning to build an addition to his home in Claremont, California. "The cost of adding on is less than the cost of what homes are selling for per square foot," he reasons. He plans to pay for the construction by refinancing his 30-year fixed-rate mortgage at an interest rate of 5.75%, almost two percentage points lower than the rate he got five years earlier when he bought his home. He'll save thousands of dollars in interest payments.
Since hearing news of the economic recovery--increased gross domestic product growth, lower unemployment rates, and more jobs--accompanied by higher prices, inflation, and the expected rise of the federal government's short-term interest rate, both men are doing what they can now to protect their real estate and business holdings. With the economy expected to remain volatile in the short term, here are some things consumers and investors can do to help ease the pinch of rising interest rates:
Stay fixed in real estate. The average 30-year fixed-rate mortgage remains well below the low watermark for the 1990s. which was 6.83%, says Keith Gumbinger. vice president of HSH Associates, publisher of mortgage information. Still, those in the real estate market say rates are beginning to feel upward pressure.
Reggie took out seven loans to acquire or renovate his McDonald's franchises. Most of the loans have a life of seven years and interest rate caps that range from 2.5% to 4.5%. Two of the loans are fixed; the other five have floating or adjustable rates that can be fixed once during the life of the loan. Reggie says he tries to keep a blend of fixed- and floating-rate loans so he can benefit from market conditions on at least a portion of the debt he carries: "If I see interest rates beginning to rise dramatically, and it looks to me like they will continue to rise, I can fix some loans at whatever the fixed rate is on that date." Reggie intends to obtain a fixed-rate loan to acquire his twelfth franchise. "That way, I'll lock in my rate [at near historic lows] and it won't go up over the course of the seven years," he explains.
To select the best mortgage, you should have a pretty good idea of how long you plan on being in the home, says Gumbinger. A fixed-rate mortgage remains a very attractive deal and is probably best for anybody who intends to stay put for about seven years.
For others, 30 years of fixed-rate stability may not be worth the price. For those buyers, Gumbinger suggests hybrid adjustable-rate mortgages (ARMs), which feature a fixed interest rate usually for three, five, seven, or 10 years until they turn into traditional adjustable-rate mortgages. In this category, 5/1 ARMs are the most popular; they're fixed for five years and adjusted annually thereafter. Currently, ARMs are available at an interest rate around one percentage point below the comparable 30-year fixed rate.
If you're considering refinancing to get cash for home improvements or to switch to a better interest rate, compare your current spending to the cost of getting a new mortgage. If you've been in your home for a while or have an extraordinarily low interest rate, it doesn't make sense to refinance your loan to get cash at the expense of adding years to your mortgage at a higher interest rate.
If you are currently stuck with a sub-prime loan (high-interest loans given to people with poorer credit ratings), you might consider a longer-term fixed-rate mortgage if you qualify. It may buy you some certainty in your monthly budget as interest rates rise.
Maintain a diversified portfolio. The stock market generally responds negatively to rising interest rates, meaning that many issues may lose value. While some investors see this as a great opportunity to go hunting for discounted stocks, this is also a time when investors might do well to pull back their exposure to stocks by about 10% to 20%, says Sanford Coggins, former Merrill Lynch financial adviser and investments vice president.
Coggins advises clients to diversify their equity holdings so that nearly every sector is included. For example. 10% or 15% of equities could be devoted to the utilities and energy sectors, which generally do well in a money-tightening environment. Coggins suggests simultaneously adjusting your portfolio weightings away from sectors that are sensitive to interest rates, such as financial services. "The average investor should probably look at the S&P 500 weighting and then balance off of that," he says. "Then take [industries] such as energy, healthcare, or utilities and start moving ever so slightly [until about] 15% of the portfolio is invested in those sectors." According to Coggins, this strategy should help the investor outperform the S&P but not lose his shirt if he's wrong.
Keep bonds short. Since long-term bonds suffer with rising interest rates, reducing the maturities in a bond portfolio will result in less volatility, explains Coggins. "The average maturity should be somewhere in the three- to five-year range versus the 20- or 30-year bond that you can hold in a portfolio while interest rates drop."
Harriet Jones, 40, is the CEO of her own real estate brokerage firm in Durham, North Carolina, and she has taken a more balanced approach to diversifying her portfolio. Rising interest rates can signal an opportunity to add bonds to you r overall mix of investments.
"[Jones] has a 50-50 allocation between equities and fixed income," says her adviser, Ed Fulbright, president of the Durham-based financial planning firm Fulbright Financial Consulting P.A. "Last year, her fixed-income holdings were in cash, so she was earning less than 1%."
Fulbright devised a fixed-income portfolio for Jones that has raised her yield to around 5%, yet minimizes her exposure to rising interest rates. "Some of Harriet's money is now invested in a pool of secured bank loans," he says. "If the prime interest rate rises--as most people anticipate--the interest on those loans will rise, too, and her yield will increase." (See "Follow the Banker," Moneywise, July 2004.)
"Harriet also has some money invested in a bond ladder--a series of bonds that will mature in one, two, three, four, and five years. When the one-year bonds mature, her money can be reinvested in new five-year bonds, which may be paying higher interest rates. And so on each year," says Fulbright.
Investors can use Treasury Inflation-Protected Securities (TIPS) and Series I Savings Bonds as ways of preserving capital against inflation. TIPS are marketable Treasury securities with varying maturities that pay a fixed rate of interest every six months applied to an inflation-adjusted principal. Upon maturity, TIPS pay the greater of the inflation-adjusted principal or the original par value. You can purchase TIPS through www.TreasuryDirect.com.
TIPS made the most sense as a long-term buy and hold in June when the interest rate on 10-year TIPS was about 2.8% lower than that of a nominal 10-year Treasury note. That's more than the current rate of inflation, which is about 2%. Investors will have to be careful to look for a similar competitive advantage on rates this fall. Also, since the investor pays federal taxes on the principal in any year it grows, TIPS work best in tax-deferred retirement accounts that allow for long-term investing.
I Bonds, like TIPS, have built in protection against inflation: an interest, rate that is adjusted to the Consumer Price Index every six months, in addition to a fixed interest rate that lasts the life of the bond. Coggins recommends I Bonds for a portfolio's short- to intermediate-term segment.
Overall, Eugene Flood, CEO of the fixed-income investment firm Smith Breeden Associates, says investing in short- to intermediate-term bonds (bonds with maturities under 10 years) is the best way to go. Flood recommends bonds with a two-year maturity and encourages investors to look at "mutual funds that hold those type of securities, especially mortgage hacked securities. Mortgage-backed securities have higher yields when interest rates move higher."
Pay off debt now. For those grappling with sizeable debt, the threat of rising interest rates is a wake up call to begin an aggressive repayment schedule. When mortgage rates were at rock bottom in the 1990s, many homeowners took out home equity loans and lines of credit to consolidate their debts. The interest rates on these forms of credit are lower than the average credit card and they're tax-deductible. But as rates go up, using your house to pay off debt may not be wise. Wily refinance and extend the term of your first mortgage?
In addition, after you refinance, "you've tied up your home equity for debt that was previously unsecured. So you up the ante in terms of consequences of default," says Greg McBride, senior financial analyst at Bankrate.com. Also, ask yourself if it makes sense to take out a 10-year home equity loan to pay off credit card debt that could possibly be paid off much sooner.
As for credit cards--typically the most expensive debt anyone can have--even a fixed rate card doesn't protect you from higher interest rates, says McBride. When banks raise their prime interest rate, fixed rate cards adjust like variable-rate cards, only at less frequent intervals. In June, a standard fixed-rate credit card carried an average interest rate of 12.87%.
It's always a good idea to take advantage of offers to transfer your credit card balances to a card with a low rate or one that won't charge you any interest for a limited period of time. As long as you can pay off the balances in full while the rate applies, you'll avoid the high interest rate.
Depending on your risk tolerance, rising interest rates don't have to be bad news. In fact, for those who have been earning little or nothing on their money market and savings accounts, rising interest. rates are welcome news because the interest that those accounts earn is likely to be higher as well. With a little planning, just about everyone can benefit from rising interest rates.
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|Title Annotation:||Money Management|
|Author:||Korn, Donald Jay|
|Date:||Sep 1, 2004|
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