Interest rates play a pivotal role in our economic landscape, making them an aspect of financial planning we pay close attention to. Not only do interest rates affect the ups and downs of investment portfolios, they shape our day-to-day financial activities like saving cash, borrowing money, and paying off debt. As a result, it’s crucial for us to adapt financial planning strategies for our clients when rates change. In this post, we’ll explore what it means to be in a high(er)-interest rate environment, how to best leverage your cash savings, and how higher interest rates affect our approach to financial planning.
Understanding High-Interest Rate Environments
Interest rates today are higher than what we’ve seen in about 20 years, but, relative to historical rates, they are not the absolute highest. It’s possible that we’ll see interest rates stay at this level for quite some time and possibly even increase. You can take a much deeper dive into this topic by reading Howard Marks’ recent memo, Easy Money.
For the purposes of this post, a high-interest rate environment refers to a period in which borrowing costs are elevated. The Federal Reserve, the central banking system of the United States, sets interest rates to achieve different economic objectives. A primary reason for raising interest rates is to control inflation, i.e. the rise of the costs of goods and services. By making borrowing more expensive, the Federal Reserve aims to slow down spending and keep inflation in check.
Impact on Borrowing and Financing
One of the immediate effects of higher interest rates is the increased cost of borrowing money. With high interest rates, people may find it more expensive to finance projects like home renovations or large purchases like cars. Mortgage rates are a perfect example of this, with an average rate of 7.21% in January 2024, compared to just a few of years ago in 2021 when they were closer to 3%
In this economic climate, we usually advise clients to build and maintain more liquidity in cash savings. Having more cash on hand means more flexibility to foot the bill for large purchases on your own instead of borrowing money at high interest rates. In the case of a mortgage, putting more money down at the beginning reduces the carrying costs of the home over the long-term, especially when rates are higher. The same strategy applies to other large purchases where financing is a consideration.
Leveraging Cash Savings
High-interest rate environments also present opportunities for cash savings. High-yield savings accounts, Certificates of Deposit (CDs) and money market funds become more attractive as they offer higher yields compared to times of lower interest rates.
- High-Yield Savings Accounts: A high-yield savings account is a variable interest savings account that tracks its interest rates in real time to whatever interest rate is set by the Federal Reserve. Only certain banks offer these accounts. Online banks, like Ally, Marcus, and Capital One can offer high-yield savings because they don’t have overhead costs associated with brick and mortar banks. We recommend these to all of our clients who are keeping extra cash savings in the bank for things like emergency funds or saving for large purchases in the next one to two years. When choosing between them, go with the user experience you like best as they essentially all provide the same service (although our favorite is Ally). I’ll note that even if interest rates are low, it’s still worth it to keep your cash savings in high-yield accounts. Again, this is because they’re flexible, and the interest rate will always be at least as high as any other bank.
- Certificates of Deposits (CDs): Unlike the high-yield savings accounts, CDs provide a fixed interest rate over a specified period, offering predictability. We typically recommend these to clients only when they’re certain about both the amount of cash they can put away and the timeframe. CDs usually make sense when you have a significant amount of extra cash beyond your emergency fund. We don’t recommend putting emergency savings into a CD, because locking it away would defeat the purpose of being able to dip into those funds at a moment’s notice.
- Money Market Funds: In high-interest rate environments, money market funds emerge as a strategic and effective savings tool for our clients. We leverage our ability to manage investment portfolios for clients by investing client cash into money market funds within their brokerage accounts, with a focus on the Vanguard Federal Money Market Fund (VMFXX). This fund invests in short-term, high-quality debt securities (U.S. treasury bills), allowing us to capture the highest possible interest rate available and maximize returns on our clients’ cash holdings. The interest rate in money market funds is about 1% higher than at high-yield banks. High-yield savings banks profit by lending out deposited funds at higher interest rates than they pay to account holders, while direct investment in a money market fund like VMFXX can yield higher returns as these funds are invested in short-term, higher-yielding securities tied to the current federal funds rate. Utilizing a money market fund like VMFXX allows us to safeguard clients’ cash reserves while capitalizing on the highest rate available. We usually employ this strategy when clients’ have any amount of cash beyond their rainy day fund that they’d like to invest.
Other Considerations
Beyond borrowing and saving, high-interest rate environments can impact other aspects of personal financial planning. For example, investments in interest-rate-sensitive sectors such as real estate may experience shifts in value. We may rethink the timelines of decisions on whether to sell, buy, hold or rent property.
Additionally, the cost of servicing existing debt can rise during periods of higher interest rates, specifically adjustable-rate debt. With adjustable-rate mortgages, higher interest rates affect cost of living, and we may revisit the cash flow picture and make changes to savings and investment plans. It could make sense to explore options like refinancing or restructuring to mitigate the impacts on financial well-being.
High interest rates are an example of how macroeconomic conditions can trickle down to place pressure on individuals. Since interest rates may take time to come back down, our ultimate goal for our clients is to build resilience and flexibility into their finances, largely through building and maintaining cash liquidity. By building liquidity, leveraging effective savings tools, and considering the broader implications on investments and debt management, we’re planning in accordance with our philosophy that financial plans should be very nimble and malleable. This way we can ensure our clients are well-positioned to achieve their financial goals regardless of the prevailing interest rate.
Brandon Tacconelli is the Director of Client Care at Thinking Big Financial, Inc. Thinking Big is a fee-only financial planning firm in New York City specializing in working with the LGBTQ+ Community.