SECURE Act 2.0 includes provisions affecting many areas related to retirement planning. One of the changes that hasn’t received a lot of press, however is the new requirement…
Continue readingWhy Does a Diversified Portfolio Matter?
Why does a diversified portfolio matter? Put simply; it helps reduce the risk that you’re taking with your investments. You’ve probably heard the saying, “Don’t put all of your eggs in one basket.” That saying is speaking directly about diversification.
What Does a Diversified Portfolio Look Like?
Let’s say that you have $10,000 to invest, and you’ve decided that you want to invest in electric vehicles. Investing in electric vehicles could mean a lot of things. It could mean buying shares of Tesla. The price of Tesla shares is notoriously volatile. If you invest $10,000 in Tesla and the following day, the market price is up 3%. Then you have a nice $300 gain practically overnight. Although, if the market price of Tesla is down 3% the day after you invest, then you lose $300 practically overnight.
Diversifying Your Investments
Suppose now, rather than investing the entire $10,000 in Tesla, you invest half in Tesla and half in another car company. They also happen to make electric vehicles but have other products and do not have a polarizing and vocal CEO. The second car company also has a stock price that tends to be less volatile. Potentially because it also has other products and does not have a vocal and polarizing CEO. On the day after you purchase your shares, Tesla shares go down 3%, and the shares in the other company go up a modest .5%. In this case, your portfolio would be down $250. If Tesla shares were up 3% and the second auto company was down .5%, then your portfolio would be up $250. Your potential gain was reduced, but so was your potential loss.
“Either way, if something happens that affects the auto industry as a whole, your portfolio is likely to decline in value, and neither stock would likely reduce the effect.”
Kellly Ennis – Financial Advisor & Founder of Infinity Financial Strategies
Now assume that you’ve decided that you also want to invest in something that everyone needs. You choose a company that makes toilet paper (we all learned a lesson during the pandemic) and other products that are considered consumer staples. Allowing that you split your $10,000 evenly between each of the three companies. If the consumer staple company has many products and many ways to earn money, there’s a good chance that its stock price doesn’t move too wildly. Many consumer staple companies have pretty steady stock prices.
Having this stock in your portfolio can help you have a steady base in your portfolio. Think of it as ballast in a ship. It helps mitigate the ups and downs when the ship hits large waves. This doesn’t mean that the stock price doesn’t go up and down. It just doesn’t usually move as drastically as the more volatile stocks. This helps reduce the risk in your portfolio because it isn’t particularly volatile. It also isn’t likely to move in lockstep with auto industry stocks.
The Long Haul of Diversified Portfolios
Over the long haul, the market tends to go up. The problem is that we don’t know how long the long haul has to be. There will be times when the market is down even though the long trend is upward. If we could stay invested for “the long haul” and our investments could roughly reflect “the market,” then we should expect investment gains over a long period of time. It will take quite a few positions in a portfolio to roughly reflect the entire “market.” There are stocks for roughly 2800 companies being traded on the New York Stock Exchange alone. That doesn’t include NASDAQ and other exchanges.
Take Advantage of Market Tendencies
If we can spread out the risk in an investment portfolio, we could potentially have stocks that tend to move in opposite directions. We could add in bonds, which frequently (but not always) move in the opposite direction to stocks. And bonds give an additional income source that is not dependent on the stock price. Which is another form of a diversified portfolio. In addition, we should consider international stocks, both in developed markets and emerging markets. Business cycles often occur with different timing in other countries. This means some economies will be in a growth period while others may be plateauing or even in a recession. Portfolios with a good level of diversification would be able to rely on the market’s upward trend. This would then drastically reduce the risk at the same time.
Diversified Portfolios Matter
If the CEO of Tesla makes a comment online that causes the stock price to decline precipitously, and your entire portfolio is invested in Tesla, the value of your portfolio will also decline precipitously. To be fair, the reverse is true as well. If the CEO of Tesla makes a brilliant comment or the company exceeds its target number of vehicle deliveries, causing the stock price to climb steeply, then the value of your portfolio would climb steeply as well. The question is, can you stomach these wild swings? Holding shares of multiple companies and investments with differing characteristics can reduce the wild swings in your portfolio value.
In short, diversified portfolios matter a lot when reviewing the full picture of your financial health and portfolio health.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.
Should I Keep an Eye on the “Dow”?
Any investors listening to the morning radio or turning on television during the week have heard the performance of the Dow Jones Industrial Average. The investing media pundits seem to go into a wild panic whenever it falls and rejoice whenever it rises. A popular question, though, is why?
The Origins of the DJIA
To understand what the Dow Jones Industrial Average (DJIA), which is known to many simply as “the Dow”, means, first, you have to know what it meant back when it began. The precursor to the Dow Jones Industrial Average started in 1896, and its purpose was to provide a measure of how the industrial economy was performing. To do that, it started with 12 companies.
The American Cotton Oil Trust, which dominated the cotton oil industry, is now part of Unilever. American Sugar, which was the main producer of sugar for the United States with plantations in Puerto Rico and other Caribbean nations, was bought by Domino Sugar. American Tobacco, which was broken up by the SEC into multiple companies. Chicago Gas, which has now become Integrys.
Distilling and Cattle Feeding, which oddly enough produced whisky and had nothing to do with feeding cattle. General Electric, still exists today but was removed from the Dow in 2018. Laclede Gas was and still is a natural gas company in Missouri. The North American Company was a holding company with interests practically everywhere. National Lead, which was the biggest company in the lead-smelting industry. Tennessee Coal, Iron, and Railroad, which was a major mining and transport company. U.S. Leather was dissolved after antitrust lawsuits, and U.S. Rubber, jumped from owner to owner until it was bought by Michelin in 1990.
These dozen companies spanned nearly the entire industrial sector of the United States, and that was the goal–to ultimately sum up the industry of the United States with an average. As companies fell apart, and new companies rose through the ranks, the Dow added and removed companies. In fact, none of the original 12 companies are on the current Dow, which is now comprised of 30 companies.
The Wall Street Journal
A more modern incarnation of the DJIA was first published in the Wall Street Journal in 1916. That index included 20 stocks–eight from the old index and 20 new stocks. In 1928, the index expanded to 30 stocks.
Today the Dow isn’t necessarily the most important measure of the stock market and the economy. With the rise of more indices, both broader and more specific, there are more ways to quantify the performance of the stock market and, more importantly, your own portfolio. The S&P 500 is an index of 500 stocks spread across the entire nation in various industries, and there are countless indices for specific sectors of the economy.
Does the Dow Do a Decent Job of Diversifying?
Throughout the entire economy of the United States, it is very difficult to create a thorough and complete picture of the economy with only 30 stocks. If your portfolio was heavily based in the automotive and oil industries, then the Dow wouldn’t really reflect your portfolio; the Dow does not currently include any stocks in the automotive or oil industries. Similarly, if your portfolio is based in companies outside of the United States, the Dow couldn’t represent your portfolio; all of the stocks in the Dow are based in the United States. That being said, almost all of the companies represented in the DJIA do have a worldwide business and could be affected by political factors.
The Dow
Ultimately, it is important to realize that the Dow, in most cases, doesn’t represent your portfolio. If you wake up one morning and see that the Dow has dropped 8%, your portfolio won’t match that exactly unless you are solely invested in a Dow Jones Industrial Average Fund. Because the Dow only represents 30 companies, the change in the price of one stock can drastically change the value of the entire average, while in indices like the S&P 500, it would take a much larger change in one stock to sway the entire average.
Noteworthy
Also worth noting, the Dow is what is called a price-weighted index. This means that the stocks with a higher trading price are weighted more heavily than the stocks with a low trading price. For example, Caterpillar(CAT) is currently trading at around $287.57, while Walt Disney Co (DIS) is currently trading at around $86.30. Even though the market capitalization of Disney is actually higher than the market capitalization of Caterpillar as of July 28, if the prices of both stocks were to increase by 2%, Caterpillar would have an impact on the index worth about three times Disney’s impact on the average. (Market capitalization is the value of all of a company’s shares of stock outstanding, and different companies have different numbers of shares of stock outstanding.)
Who Created the Dow Jones?
And why is it called the Dow Jones Industrial Average? The index was first compiled and reported by two financial reporters, Charles Henry Dow, and Edward Davis Jones, who founded a company called Dow Jones & Co. The DJIA was only one of the indexes they created around that time; they also reported on an index comprised of 20 railroad companies which would later become the Dow Jones Transportation Index.
The NASDAQ
To sum it up, the Dow Jones Industrial Average has a really interesting history (if you’re into that sort of thing), and it gives an indication of the performance of a carefully curated selection of companies in the U.S. economy. However, it includes only 30 of the approximately 2800 companies trading on the New York Stock Exchange and 3300 companies on the NASDAQ. In addition, the DJIA only includes large company stocks. What does this mean to you as an investor? A large swing in the Dow probably doesn’t mean that your portfolio increased or decreased by the same percentage as the Dow. But, a large swing in the Dow is often indicative of significant events on the world stage.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.
What is Index Investing
You’ve probably heard of index investing. In fact, if you’ve heard of Jack Bogle and Vanguard, you’ve almost certainly heard of index investing. Jack Bogle was the founder of the Vanguard Group, which created the first index mutual fund.
Why Does This Matter?
Index investing allows investors, including individual investors, to get broad market exposure at a relatively low cost. With index investing, a fund holds the components of a predefined investment index.
The manager of the fund is responsible for ensuring that appropriate amounts of the index components are held in the fund rather than being responsible for choosing what securities to hold. An investor then buys into the fund. This allows investors to have exposure to each of the components of the index without having to actually purchase and hold shares in each of the companies that make up the index. As an investor, you could choose to invest $10,000 into an index fund even if purchasing single shares of every company in the index might require a $20,000 investment.
What Exactly is an Index?
An index is a collection of investments that have some factor in common distilled down to a number that represents the aggregate performance of the component pieces. Examples of indexes are the Dow Jones Industrial Average (DJIA), the S&P 500, and the Nasdaq 100 index, which are broad-based indexes often used to gauge the performance of a broad market. Then there are indexes intended to provide information on the performance of certain segments of the market, such as the Russell 2000 Index, which includes small-cap stocks, or the PHLX Semiconductor Index (SOX), which tracks the performance of companies that produce semiconductors.
The calculation of the value of the index varies from index to index. For instance, the DJIA is a price-weighted index meaning that the value is computed based on the price per share of each of the components. On the other hand, the S&P 500 index is calculated based on the market capitalization, the total number of shares outstanding multiplied by the price of the shares of each of the components. Some indexes use a combination of price, market capitalization, the aggregate market capitalization of all securities in the index, and other factors. Since the calculation of these indexes varies widely, it often makes more sense to pay attention to the change and direction of change of an index rather than the index value itself.
Who Creates an Index?
Indices can be created by anyone. However, the most well-known and followed indexes are often created by fund managers, investment banks, or brokerages. See our recent post about the history of the Dow Jones Industrial Average. The creator of the index defines the concept behind an index and the rules that will apply to the index, including how component securities will be chosen and the calculation of the index value. Then, the index provider will start calculating and communicating the index according to the method and rules they have established.
Periodically, the index may need to be rebalanced to bring it back in line with the established methodology due to events like mergers, spin-offs, stock splits, etc. Ultimately, the index provider makes money on their index by licensing their indices to portfolio managers who may build products like ETFs and mutual funds from the index. In addition, the index providers can license the index to media that report the value of the index in real time.
What’s the Benefit of Index Investing?
One of the benefits of index investing is that it removes stock-picking and market timing from the picture. If you buy into an index fund, you will be gaining exposure to the components of that index based on the weightings established by the index at the current price. There is no waiting for the price of a particular company’s stock to reach a certain level, and there’s no guessing when to sell a particular stock because it might be at its high. All of the buying and selling of individual securities occurs based on the rules of the index.
It provides broad exposure to a segment of the market at a relatively low cost. To buy just one share of the 10 largest companies in the S&P 500 index would cost you at least$8000. Or, you could get exposure to 500 companies with just a small investment by purchasing shares in an S&P 500 ETF or mutual fund.
And the index acts as a benchmark. You would think that all funds based on the S&P 500 would have the same performance, but you’ll find that isn’t necessarily true. One reason may be due to the difference in expense ratios charged by different funds. Another reason may be due to the timing of trades when the fund ensures alignment with the index. And there may even be a difference depending on the pricing that a large broker-dealer who provides a fund can get versus a smaller fund provider.
Are There Drawbacks?
There’s always a balancing act when deciding to let someone else choose your investments. Both ETFs and mutual funds have fees associated with them. Part of those fees go towards marketing those funds and paying for the folks who keep the funds compliant with regulations and reporting requirements, as well as the actual traders. But another part of those fees pays for the licensing of the index being used by the fund.
In some cases, the portfolio manager itself is providing the index and managing the fund. This can work out in their favor or the investor’s favor depending on the licensing fee being paid for the use of the index. With a widely-used index, there are many licensees paying the fee for the license, and therefore, it is likely a lower fee. With indices without a broad-based following, you may see the portion of the fee going to the licensing company is rather large.
Another potential drawback is that indices generally have rules regarding the timing of additions and deletions from the index and when the index is reconstituted. This could mean that a company that you feel is a poor investment is still in the index when you might have sold that stock if you managed the funds yourself. This is part of the price you pay for broad exposure for a relatively low cost.
Is Index Investing the Answer?
As usual, the answer is “It depends.” It depends on the question you’re asking, and it depends on your goals and available resources.
Index investing does take the emotion out of investing, for the most part. You may still try to time the market when buying into a particular sector, but you won’t be trying to time the market regarding a particular company. Index investing does allow investors to gain exposure to a large number of companies without needing the capital to buy actual shares in each individual company. But, you do give up a degree of control in exchange for using the funds that depend on predefined indices.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.
Financial Aid for College – 2024
The Foundation of the Financial Aid Process
If you’re looking for financial aid for college, the Free Application for Federal Student Aid, better known as the FAFSA, is most likely the place to start. This form, administered by the U.S. Department of Education, is used to gather information about prospective student and their family and their finances to determine their eligibility for federal student aid.
The FAFSA is usually available on October 1 of the year prior to the year in which any financial aid award would be used. However, due to the extensive changes resulting from the FAFSA Simplification Act, the opening date for the FAFSA in 2023 will be December 1.
How Does This Affect Me?
Whether this change in date affects you and how it affects you depends on your situation.
If you are applying to schools as a freshman, and you were considering Early Decision or Early Action, AND you will need financial aid to attend your school of choice, you may have to wait longer for a financial aid package compared to earlier years. In past years, the deadline for financial aid applications for Early Decision applicants was as early as November 1 or November 15. And, many Early Decision and Early Action notification dates are in December. This year you may find that notification dates have been pushed later, or you may find that financial aid information is not available at the same time as admissions offers.
What Should You Take into Account?
If you are applying for financial aid as a returning student, and you are dependent on federal financial aid, you have a couple of things to consider. The methodology behind the FAFSA calculations is changing. These changes may result in changes to your ability to qualify for Pell Grants or subsidized student loans. So, it is a good idea to complete your FAFSA as soon as possible after it opens. While you can’t change the outcome of these calculations, the sooner you know where you stand with the new FAFSA methodology, the sooner you can work on your strategy to pay for college.
If you are applying for financial aid as a returning student, and you are dependent on financial aid from your school, and your school requires the FAFSA, you will still want to complete the FAFSA as early as possible once it opens. Schools do run out of financial aid funds, and the sooner you complete the application for financial aid, the better chance you may have of being awarded need-based financial aid if you qualify.
The Changes in the FAFSA
The intention of Congress when passing the FAFSA Simplification Act was to – simplify the FAFSA! Many students who would have qualified for financial aid never completed the FAFSA due to its complexity. The new FAFSA will have fewer questions and will be able to rely more directly on your tax returns which reduces the amount of information that you need to enter.
However, there are other changes as well. For example, rather than receiving an Expected Family Contribution when completing the FAFSA, you will receive a Student Aid Index. Assets that need to be reported have changed for some people, such as business owners. And there will be some changes in what needs to be reported as income for some people.
Preparing for These Changes
This FAFSA season will be different. It will be critical to pay very close attention to the questions and to provide the information requested. You won’t be able to assume that they’re asking for the same information that you have provided in past years.
This FAFSA will be new for everyone. You may need to exercise patience as you work with schools, scholarship programs, and others who rely on the FAFSA to award financial aid.
“Schools are Adjusting Deadlines“
Be sure to research any timelines that apply to you. Schools are adjusting their deadlines for financial aid applications. In some cases, these new deadlines will give you a smaller window to apply between the date the FAFSA opens and the deadline.
Be aware that you may have to make some decisions in a relatively short timeframe. While most financial aid packages from schools are subject to change each year based on your family’s evolving circumstances, these FAFSA changes may result in unexpected changes.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.
Essential Household Savings Accounts & Why You Need Them
EVENTS & OPPORTUNITIES FUND
There are a few accounts that households should have set aside for different purposes. We’ve talked about the Emergency fund and the Rainy Day fund, and in the future, we’ll address funds for specific purposes or goals. Today we’re talking about the Events and Opportunities fund.
An Events and Opportunities fund can be helpful to take some pressure off some financial decisions. However, it probably ranks below the Rainy Day funds and definitely below the Emergency Fund in terms of importance.
An Events and Opportunities fund is used for things that come up that are unexpected but not emergencies. The event or opportunity would benefit you if you could participate, but it won’t leave you worse off if you don’t participate.
Here’s an example. Taylor Swift is currently on tour as I write this article. Tickets for her concerts cost a pretty penny if you can get them, but they have been incredibly difficult to get. Many who anticipated this concert and set aside funds for the tickets haven’t been able to actually get the tickets. You would love to go, and even more so, your daughter would love to go. But you didn’t set aside funds for this financially, and you wouldn’t even know where to start looking for tickets once the usual channels are exhausted. Now, imagine that the day before the concert, you get a call from a friend. They have tickets for the concert, but they have COVID and won’t be going anywhere for a few days. They offer you the tickets at a fair (fair is all relative) price. What do you do? If you decide that you will benefit from going to this concert (enjoyment, memories, etc.), then you use your Events and Opportunities Fund, buy the tickets from your friend, give them your wishes for a speedy recovery, and go enjoy the concert.
Or, here’s another example. The Smiths decided that they’d like to install a pool next summer. They started getting quotes in the fall and ran into two issues. First, the cost was much higher than they anticipated because pools and their installers became much more in demand during the pandemic.
Second, the pool companies were unavailable until the year after they wanted it installed due to the increased demand. They pretty much gave up on the idea until one of the companies reached back out to them because, as it turned out, they would be installing pools for two other neighbors very close by. Because the equipment and workers would already be in the neighborhood, the pool company would be able to install their pool as well and at a better price than originally quoted, but only if it was at approximately the same time the neighbors were having their pools installed. And the installation date was in the spring, so they would even be able to use the pool the following summer. This meant the Smiths would be able to get their pool, but it would be sooner than expected. Once more, this would use your Events and Opportunities Fund.
Other instances would include types of entertainment events, opportunities to travel, and perhaps purchases that didn’t make your list of specific goals but an opportunity that presents itself that is mutually beneficial to you and the seller. In some cases, investment opportunities (well-vetted and aligned with your risk tolerance and overall financial plan) present themselves.
Again, this type of fund is intended to take some pressure off financial decisions, but not all. You must decide if the presented opportunity or event is worth your hard-earned dollars. The difference is that if you have the funds for these events and opportunities as they present themselves, you won’t derail the rest of your financial plan.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.
Essential Household Savings Accounts & Why You Need Them
Rainy Day Fund
A rainy day fund is different from an emergency fund–but it is still incredibly helpful for your peace of mind.
A rainy day fund is used for those relatively small and somewhat expected expenses that happen, but you can’t necessarily count on the timing. Imagine that your everyday life is a series of sunny days where you go about your daily life following your routine. Rainy days happen now and then and may disrupt your routine. Sometimes the disruption is welcome; sometimes, it isn’t.
Here are some examples of when you might use your rainy day fund.
Depending on your age and stage of life, you probably find that certain events happen in clusters. Weddings, births, graduations–etc. You know that these events may be coming, but you don’t know when. Travel for these events can be expensive depending on when and where they are. And then there’s the cost of gifts. These would be appropriate expenses for the rainy day fund.
Let’s say you have children, and they are on school break. And, you literally have a rainy day–or worse, a string of rainy days. This is when you dip into the rainy day fund and plan an event. It could be a short trip, an educational experience, or just rain boots and raincoats so you can all go out and play in the rain.
Other examples of uses for rainy day funds would be medical co-pays or coinsurance payments and veterinary bills for regular checkups. You might also use the fund for the replacement or repair of small electronic devices, sports equipment, minor car repairs, and home maintenance expenses.
A rainy day fund differs from your emergency fund. Emergency funds are used to help cover large, unexpected expenses like major car repairs, major home repairs or large medical bills. The rainy day fund is used for smaller expenses that you know you are likely to incur, but you don’t know the timing, and you don’t know exactly how much they will be.
So, how much should you keep in your rainy day fund? As usual, with financial questions, it depends. If you have a large family, including your pets, then you’ll want to add more to your rainy day fund to help with those insurance co-pays and vet bills. If you and your household depend on electronic devices(don’t we all?), then you’ll want to add more to your rainy day fund as well. Take a look at what could happen in the next year to help you determine an amount. How old are your cell phones? How likely is it that you’ll need to replace them this year? How about iPads and other devices? What about small home appliances like coffee makers and toaster ovens/air fryers/etc., that you depend on? How much is the deductible on your car insurance? This is the amount that will come out of your pocket if there is an event involving your car. How about the kid’s activity levels? Will their activities likely lead to expenses like new sports equipment (or medical co-pays)?
The rainy day fund, like the emergency fund, helps with peace of mind. You can design your spending plan and account for all of the regular expenses.
However, everyone experiences unplanned–though
not necessarily unexpected–expenses from time to time. Your rainy day fund can help you cover those expenses without derailing the rest of your financial plan.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.
ESSENTIAL HOUSEHOLD SAVINGS ACCOUNTS & WHY YOU NEED THEM
What is an emergency fund? A savings account that consists of liquid reserves that you have set aside for unanticipated but necessary expenses…
Continue readingBENEFITS TO HIGHER INTEREST RATES
By now, you’ve undoubtedly heard that “the Fed” has been raising interest rates to rein in inflation. Interest rates are an essential part of our economy, and their impact can be felt by nearly everyone who participates in financial activities. The federal reserve raises interest rates to restrict access to funds and hopefully slow down the rate of increase of prices, including wages, in the economy. While this sounds like an awful idea if you are a borrower or have used access to cheap money to grow your business, higher interest rates can positively affect savers and lenders. If you are a saver, higher interest rates mean you can earn more money on your savings. This can be really helpful if you are saving for a specific goal, such as buying a house, starting a business, or saving for retirement. With higher interest rates, your savings will grow at a faster rate, allowing you to reach your financial goals sooner. Another advantage of higher interest rates for savers is that they can help to combat inflation. Inflation is the rise in the cost of goods and services over time, and it can erode the value of your savings. In other words, if the prices of the goods you buy rise faster than the value of your savings, your savings can’t buy as many goods. However, if you are earning a higher interest rate on your savings, you can offset the effects of inflation and maintain the purchasing power of your money. For lenders, higher interest rates mean that they can earn more money on the loans they provide. This can be particularly beneficial for banks and other financial institutions that make a significant portion of their revenue from interest on loans. Higher interest rates can also encourage more lending, as lenders are more likely to provide loans when they can earn a higher return on their investment. And, when you purchase a bond, whether a government bond or corporate bond, you also become a lender and can benefit from higher interest rates. Retirees and others who live on fixed incomes are often savers and lenders—a large part of their income is often the interest generated from savings deposits and bond interest. After nearly a decade of extremely low interest rates, these new higher interest rates are a real boon to those living on fixed incomes. Another advantage of higher interest rates for lenders is that they can help to stabilize the economy. When interest rates are low, borrowing becomes cheaper, and consumers and businesses are more likely to take on debt. However, this can lead to an increase in inflation and a potential economic bubble, and in some cases, poor management decisions. Low interest rates can allow a company which is either poorly run or may not have an economically feasible business model to continue operations simply by borrowing cheap money. By raising interest rates, lenders can discourage excessive borrowing and prevent an economic crisis. Higher interest rates will have a different effect on savers and lenders versus borrowers. Savers can earn more money on their savings, combat inflation, and reach their financial goals faster. Lenders can earn more money on loans, stabilize the economy, and prevent potential economic crises. While borrowers may have to curtail spending in order to accommodate the higher cost associated with borrowing. While there may be some drawbacks to higher interest rates, the benefits for savers and lenders are significant.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.
IMPACT OF HIGHER INTEREST RATES
While higher interest rates can be beneficial for savers and lenders, as we discussed in our last post, there are also several drawbacks to consider. In this blog post, we will explore some of the potential disadvantages of higher interest rates.
One of the most significant impacts of higher interest rates is that they can lead to increased borrowing costs for consumers and businesses. When interest rates rise, it becomes more expensive to borrow money, which can reduce consumer spending and business investment. This can lead to decreased economic growth, as businesses are less likely to expand and hire new employees. In fact, the employment numbers and wage levels are key economic indicators the Federal Reserve is using to determine when and the degree to which they should raise rates.
Higher interest rates can also have a negative impact on the housing market. When interest rates are high, fewer people can afford to buy homes, which can lead to a decrease in demand and a drop in housing prices. This can be particularly problematic for homeowners who are looking to sell their homes for those who are in the process of buying a home. In some cases, it leads to consumers feeling “trapped” in their current homes because they currently have low fixed mortgage rates. Because mortgage rates are so much higher than they were just a few years ago, taking out a loan of the same size as the original loan to buy a new house can lead to a drastically higher mortgage payment.
Another potential drawback of higher interest rates is that they can lead to a decrease in the stock market. When interest rates rise, investors may sell their stocks and invest in safer, fixed-income securities such as bonds. This can cause a decrease in demand for stocks, which can lead to a decrease in stock prices. In addition, higher interest rates increase the price that businesses pay to borrow. Businesses that rely on cheap money (low-interest rates for borrowing), they may be unable to sustain the growth that they’ve had. And in some cases, a company may not be able to continue operations if the money it borrowed was subject to floating or variable interest rates and the payments have now simply become too large for the company to continue making payments.
Higher interest rates can also lead to an increase in the value of the currency. When interest rates rise, foreign investors may be attracted to invest in the country, which can cause an increase in the demand for the currency. While this may seem like a positive outcome, it can also make exports more expensive, which can harm businesses that rely on international trade.
Finally, higher interest rates can lead to an increase in the national debt. When interest rates rise, it becomes more expensive for the government to borrow money, which can lead to an increase in the national debt. This can have long-term consequences for the country’s financial health and can lead to a decrease in government spending on programs, including healthcare and education.
While higher interest rates can have benefits for savers and lenders, they also have several drawbacks to consider. These include increased borrowing costs for consumers and businesses, a negative impact on the housing market, a decrease in the stock market, an increase in the value of the currency, and an increase in the national debt. When considering the impact of higher interest rates, it is important to weigh both the potential benefits and drawbacks before making any financial decisions.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.