How to Prepare for Rising Interest Rates

How to Prepare for Rising Interest Rates

How to Prepare for Rising Interest Rates

Hi everyone, it's Kris!

Interest rates are hovering near zero and are at historic lows.

And if you take a look at interest  rate history throughout the years you'll see that they've been at  historic lows for quite some time.

The federal reserve has indicated that it plans to keep interest rates low until at least 2022.

However, recent inflation worries  have led people to believe that the fed may rise interest  rates sooner rather than later.

What we do know is interest  rates cannot stay low forever!

Even though interest rates are low now, you should start to prepare yourself  for when interest rates rise, whether that be next year, the year after, or even the year after that.

There are things you can do now to prepare.

So here's what you can do.

The first thing you can do is  invest in short-term bonds.

Bonds do tend to decrease  when interest rates increase but the interest payments  associated with bonds increase when interest rates increase.

Here's what I mean.

Let's look at long-term bonds.

Long-term bonds are locked into low  interest rates for the next several years.

However when interest rates start to rise bond investors will be drawn to short-term bonds because these newly issued short-term bonds are going to have higher interest rates.

And the reason that long-term bonds end up having lower prices in a  rising interest rate environment is because investors don't want  to pay face value for these bonds because they could get a better  return with short-term bonds.

As a result, long-term bonds fall in price because investors will only  take them at a discount.

Why would anyone want to buy a  long-term bond at a low interest rate when you can get a better  return on a short-term bond?!

And there's another reason short-term bonds are more favorable in a rising  interest rate environment.

Because they're short-term bonds when those bonds come to term you can invest that money  into another short-term bond that has an even higher interest rate than before.

Short-term bonds reach their maturity date much more quickly than long-term bonds.

By continuing to invest in  short-term bonds year after year you'll be increasing your interest payment  in a rising interest rate environment.

Whereas, if you were to buy a long-term  bond in a rising interest rate environment you'd be locked into that interest  rate for the next several years.

Aand if you're interested in  buying some short-term bonds, you could look at Vanguard's  Short-Term Bond Index fund, VBIRX.

Or you could look at Vanguard's  Short-Term Bond ETF, BSV.

The next investment you can make in  a rising interest rate environment is Treasury Inflation-Protected Securities or TIPS.

Treasury inflation-protected  securities are tied to inflation.

So when inflation increases, the  principal value of a TIPS increases.

TIPS in particular are tied  to the Consumer Price Index.

The consumer price index rises with inflation.

And since the principal amount of a  TIPS is tied to the Consumer Price Index When inflation goes up, the consumer price index goes up, and, thus, TIPS go up.

So you might be wondering, how does the TIPS work?

With the Treasury Inflation-Protected Security, you invest a principal amount of money and it's for a set amount of time.

And on that principal amount of  money you get interest payments. 

As I stated before the principal  amount is tied to inflation.

So if inflation goes up, your  principal amount goes up.

With TIPS you can get two kinds of growth.

The first type of growth is the  principal amount based on inflation.

As inflation goes up, that  principal amount will go up.

And when the TIPS matures, you will get that inflation adjusted principle.

The second form of growth you can  get is from interest payments.

TIPS investors get interest  payments every six months.

And that interest payment is  based off of the interest rate when you start the TIPS and the principal amount.

So not only do you get interest  payments off your principal amount, but if your principal amount  increases due to inflation then you get interest payment off of  that additional inflation principle.

So your interest will grow over time.

And there is one huge bonus with the TIPS.

And that is you cannot lose your money!

Whatever amount you put in as principal is guaranteed to come back to you  when that TIPS is done with its term.

When you purchase the TIPS, it even states that you  will get one of two things: you will get back the  inflation-adjusted principal amount or you'll get back the  original amount you invested, whichever is greater.

That means if there happens to be deflation and you've invested in the TIPS You cannot lose any of your  original principal payment.

If you want to invest in a TIPS, you can do it directly from  the US Department of Treasury or you can invest in Vanguard's  Inflation-Protected Securities fund, VIPSX.

And another way you can invest your money in a rising interest rate environment is to invest in banks and financial institutions.

Banks and other financial entities  profit when interest rates rise.

Banks issue mortgages, credit cards, car loans, and other types of loans.

Especially in the case of variable rate loans, when interest rates increase,  interest payments increase.

This means that the consumers that have these types of variable rate loans will be paying more interest every single month.

And that is money in the bank, literally, for these banks.

So if you buy some bank stocks  or credit issuing stocks now, you are bound to see great returns  when interest rates start to rise.

Another thing you can do when  interest rates start to rise is create a CD ladder.

As interest rates go up, CD rates go up.

So creating a CD ladder will  allow you to take advantage of a rising interest rate environment.

Let's talk about what a CD ladder is.

A CD ladder is when you buy a  few CDs at various maturity dates and you can renew them upon maturity.

This means you could be buying  CDs every 6 months to a year as interest rates increase.

Let's look at an example.

Let's say you have $5,000 you want to put in CDs.

What you would do now is buy 5  separate CDs for $1,000 each.

You would set the first CD to mature in one year, the second CD would mature in two years, the third in three years, the fourth in four years, and the fifth CD will mature in five years.

In one year, when that first CD matures, you will renew it for a five year term.

And because interest rates are rising, you'll have locked it in for five  years at a higher interest rate than all the other CDs you  had previously purchased.

The next year the second CD is up for renewal.

You will renew it again and  set it at a five year term, and then it will be locked in  at an even higher interest rate.

Because interest rates may still be going up and you continue this process year after year, just renewing whichever CD becomes matured.

And as long as interest rates are rising, you will continue to lock in  higher and higher interest rates as your ladder grows.

And another benefit to a CD ladder is that if interest rates ever start to drop, you'll be locked into those high  interest rates for at least 5 years and your investment will not be affected by the decrease in interest rates.

And you can do this as long  as interest rates go up.

However, if interest rates start to decline, you need to evaluate if it  is a smart decision for you to renew or reinvest your CDs when it comes time because if interest rates have dropped, you may be able to get a better  return on your money elsewhere.

And you can find CDs at any bank and you can find them online with online banks.

So just shop around and make  sure you're getting a great rate.

And you can also implement the same  strategy with short-term bonds.

The next thing you can do to prepare yourself for a rising interest rate environment is to refinance your home or buy a new home.

Let's look at mortgage rates over the years.

As you can see, mortgage rates  are the lowest they've ever been.

Mortgage rates have been  on the decline since 1980.

The only place mortgage rates can go now is up.

If you already have a home and a mortgage and you don't currently have  a low interest rate mortgage you should consider refinancing your home.

If you have a fixed rate mortgage, you need to lock in that low interest rate now.

Interest rates are only  expected to go up from here, so if you don't lock in that low interest rate now you may miss out on it forever.

And by refinancing to a lower interest rate you could save yourself over $100 every  single month in interest payments.

That alone sounds like a great reason to me!

If you have an adjustable rate mortgage, that mortgage interest rate is  going to change every few years.

And considering how we're only going to  start seeing increase in mortgage rates that rate that you have on your  mortgage is going to go up.

if you refinance your home now, and go from an adjustable rate  mortgage to a fixed rate mortgage, you will lock in that low payment and you don't have to worry  about your rate adjusting for the life of your mortgage.

This will save you a lot of  money because as rates go up you'd be making higher interest payments.

So that takes all that risk away.

And if you don't currently own a home, but you're thinking about buying a home and you are financially ready to do so, now is the perfect time.

Because mortgage rates are the  lowest they've been in decades when you buy that house you will get a nice low fixed interest rate.

This makes buying a home even more affordable. 

And if you wait even one year to buy that house You could see a huge increase  in monthly housing payments.

Let's go through an example.

Let's use the average US home price in 2020 which was around $320,000.

If you put a down payment of 20%, which i highly recommend doing, then you will have a mortgage of $256,000.

If you buy this house today, with the current interest rate of around 3%, your monthly payment will be one $1,079.

But if you buy this house one year from now, and interest rates have risen to 4%, then your monthly payment will now be $1,222.

By buying the same price house now, instead of one year from now, you will save yourself $143 every single month.

Now with all this being said, Please only buy a house if you  are financially ready to do so.

Do not rush into it and get yourself in trouble just because you want to take  advantage of the low interest rates.

And the very last thing that you need to do to prepare for a rising interest rate environment is to get rid of all variable interest rate debt.

If you have credit card debt or any kind of debt that has a variable rate you need to get rid of it immediately.

Because with any variable rate debt when interest rates go up, the interest payments you're going to  have to make are going to go up as well.

High interest variable debt is  something you shouldn't have anyway, but if you do have it, start  paying it off immediately, so you reduce the amount of money  you're going to spend later.

Come up with a plan to pay this  debt off as soon as possible .

You will save yourself thousands of dollars of interest payments in the future if you do this.

So what are you going to do to prepare yourself  for a rising interest rate environment?

Let me know in the comments down below.

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