Say goodbye to near-zero percent interest rates. Those rock-bottom rates that have starved your savings accounts but made it cheaper for you to borrow are expected to end in 2022, according to the Federal Reserve. That means it’s time for pre-retirees and those already in retirement to start mapping out a game plan to keep your finances in good order.
Why rates are projected to rise
At the start of the pandemic in 2020, the economy plunged into a brief, sharp recession. The Fed, whose job is to fight inflation and keep the economy growing, slashed its key short-term fed funds rate to near zero and ramped up its bond-buying program to revive the economy.
The Fed is now pivoting to a less stimulative policy to cool the economy and combat spiking inflation caused by pent-up demand and supply chain disruptions. In November, consumer prices rose 6.8 percent from a year ago, its fastest pace in nearly 40 years. At the same time, the nation’s jobless rate fell to 4.2 percent, moving the job market closer to the Fed’s goal of maximum employment. The Fed projects that it will hike its key fed funds rate three times, in quarter-point increments, in 2022. It sees the fed funds rate, now pegged at 0 to 0.25 percent, climbing to 2.1 percent by the end of 2024.
A win for income-starved savers
While the Fed’s stimulus was successful in bringing the economy back from the brink after the 2020 COVID-19 shutdown, it punished savers, especially retirees who rely on safe, steady income. Money stashed in a savings or money market account, for example, currently pays just 0.06 and 0.07 percent in interest, respectively, and a 12-month certificate of deposit, or CD, yields just 0.13 percent, according to the latest data from the Federal Deposit Insurance Corporation (FDIC). That means a $10,000 investment in a one-year CD nets a return of just $13.
“Let’s face it, low yields have been great for people who want to borrow, but low interest rates have been pretty painful for savers,” says Warren Pierson, managing director and cochief investment officer at money management firm Baird Advisors.
The good news? Some of the pain that savers have suffered will subside as the Fed pushes rates higher. “Retirees tend to benefit when rates move up,” says Gary Schlossberg, global strategist for Wells Fargo Investment Institute.
Still, savers shouldn’t expect a lottery-like windfall overnight. While rates are seen moving higher in 2022, 2023 and 2024 to about 2 percent, they’re starting from such a low base that the gains savers see on cash sitting in money market accounts and CDs will be modest. A $10,000, 12-month CD, for example, that a year from now might pay closer to 1 percent interest, still would only generate $100 in interest each year, and at an estimated 2 percent at the end of 2024, will earn just $200 in annual income. And if inflation remains elevated, the returns on your savings still won’t keep pace with the rise in prices for things you buy, such as food and furniture, personal finance pros say.
“Rates are low and modest increases aren’t going to change that,” says Greg McBride, chief financial analyst at Bankrate.com. “Even if the Fed is successful in getting inflation, now at 6.8 percent, back down to 2 percent, interest rates are a long way from 2 percent.” That means you’ll still be earning a negative return on your cash, adjusted for inflation.
And there’s another problem: Don’t expect the nation’s biggest banks to quickly boost the interest they pay on cash each time the nation’s central bank hikes rates higher by a quarter-percentage point, McBride adds. Banks are sitting on a mountain of deposits already and don’t need to raise rates to bring more cash in, he says. If you’re intent on getting the highest yield on your cash savings, your best bet is to go with an online bank, which offer far more competitive rates, McBride says.
Still, it’s a good idea for retirees to have one to two years of living expenses set aside in an emergency fund that is safe and liquid and not prone to market downturns. “Savers should think about how they can take advantage” of higher interest rates in savings accounts, says Judith Ward, a certified financial planner and VP at mutual fund firm T. Rowe Price.
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How to capture rising yields in CDs
If you’re a fan of CDs, the best way to play these fixed-income investments now is to only lock your money up in short-term CDs, such as those that mature in three, six or 12 months. When the Fed periodically hikes rates, you can roll over your short-term CDs at maturity into new higher-yielding CDs, says Schlossberg. “You are riding the rate increases higher,” he says. “If you take the view that over the next two or three years you expect rates to move up steadily, over time those yields will look more attractive.” It also makes no sense to lock in a three-year CD that the FDIC says now yields an average 0.81 percent if the Fed’s key rate is on track to yield more than that by year-end 2022.
One strategy to consider if you want to take advantage of a series of rate hikes is to ladder your CDs. Buy a three-month, six-month and 12-month CD, and when the first CD matures after three months, you can reinvest the money into a one-year CD, which will earn more than the three-month CD. The other two CDs will be three and six months closer to maturity. And when they mature, you can roll them over into one-year CDs, too.
Bond holders: short-term pain for long-term gain
Since there is an inverse relationship between a bond’s price and its yield, the bad news is the value of your bonds will fall when interest rates rise, resulting in some short-term losses. “When rates go up, your bonds go down in value,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management.
But that doesn’t mean you should give up on bonds, which provide income and diversification for your overall portfolio. The good news is that in the long run your principal loss will be made up by the higher income payments. And, just as with CDs, that means if you own individual bonds, you’ll be able to buy new bonds that offer higher yields or roll over the money you receive from maturing bonds into bonds with plumper yields. “You have to be able to take short-term pain for long-term gain,” says Bill Schwartz, managing director and certified financial planner at Wealthspire Advisors. Indeed, rising rates will soon become a tailwind for your portfolio, as you will no longer face the risk of reinvesting money at lower interest rates.
And your chances of losing lots of money on less volatile bonds are much lower than it would be with stocks, notes Brian Andrew, chief investment officer at Johnson Financial Group. Since 1926, government bonds have registered losses in only 10 percent of 12-month holding periods (and the average loss was just 1.7 percent), according to investment firm UBS. And bonds suffered losses in just 0.4 percent of three-year periods. “When bonds mature, income gets generated and the cash flow gets reinvested at higher rates,” says Andrew. “So being in a bond fund is a good thing.”
Borrowers beware: costs are going up
If you borrow money, your interest costs will rise on things tied to the Fed’s key rate, such as adjustable-rate mortgages (ARMs), home equity lines of credit (HELOCs), auto loans and credit cards. “All of those things you borrow money to buy will cost more,” Schwartz says. “Maybe the bigger house you were going to buy at 3.25 percent may not be affordable at a 4 percent or 5 percent rate.”
And if you are carrying debt on credit cards, expect to pay more in interest, too. “Higher rates are just another form of inflation,” says Bankrate’s McBride. “It eats into disposable income, and paying down debt requires more work.” But there are ways to avoid paying more in interest even as the Fed moves further along in its rate-tightening cycle. If you have a credit card, for example, the best way to keep a lid on interest costs is to pay your debt down as soon as possible, says Ross Mayfield, investment strategy analyst at Baird.
If you have an ARM or a HELOC, mortgage products whose interest rates move higher in lockstep with Fed rate hikes, it might make sense to lock into a fixed-rate mortgage now before the Fed’s first rate hike, which could come as early as March, adds Bankrate’s McBride.
“Refinancing is still very compelling now,” McBride says. “And, especially for seniors living on a fixed income that see inflation pushing their costs higher, the ability to refinance their mortgage to cut the size of their monthly payments provides breathing room in their budgets.”
Rate hikes, as it turns out, are not the end of the world. And it’s important to keep the news about the Fed’s pivot to higher rates in perspective, says Andy Smith, executive director of financial planning at Edelman Financial Engines. “Try to make sure that (you) are coming into it in the right way and remove as much emotion from it as possible,” Smith says. That means making tweaks here and there to either take advantage of higher savings rates or reduce your borrowing costs, but keeping your long-term investment portfolio, which should include both stocks and bonds, on autopilot.
Adam Shell is a freelance journalist whose career spans work as a financial market reporter at USA Today and Investor’s Business Daily and an associate editor and writer at Kiplinger’s Personal Finance magazine.