May 5, 2023
Higher Interest Rates Lead to a Paradigm Shift in Financial Planning
A little over a year ago, the Federal Reserve issued the first of nine federal fund rate increases to combat inflation. Between March 2022 and March 2023, the federal funds rate increased from 0.25% to a range of 4.75-5.00%. This rate serves as a benchmark interest rate that influences how much consumers are paid to save and how much it costs for them to borrow. You may have noticed that it has become increasingly expensive over the past year to finance big ticket items like your home or vehicle or to maintain a balance on your home equity line of credit. At the same time, the rate has affected the yields on savings instruments like savings accounts and certificates of deposit for the better. While the strategy of aggressively raising rates can affect various aspects of consumers’ lives, it also creates an opportunity to reevaluate and refresh the traditional financial planning guidance that has been in place for the past decade.
Cash Reserve Balances
In the financial planning world, a good rule of thumb is to keep at least three to six months’ worth of expenses in cash savings. For most of us, that means putting aside those funds in our savings account at the bank. However, even though borrowing costs have increased rapidly, banks have been slow to raise savings account interest rates. According to the FDIC, the national average interest rate on savings accounts stands at 0.39% (as of April 17, 2023). If your bank is still offering low annual percentage yields on your savings account, you could be missing out on significant interest earnings. High-yield savings accounts through online banks and money market funds through investment accounts are offering yields much closer to the federal funds rate in the 4% to 5% range.
For example, at Greenleaf Trust, we utilize a government money market fund as the primary option for the cash allocation in our clients’ portfolios. A government money market fund invests in a restricted pool of government-backed securities. Keep in mind that money market funds are not FDIC insured like savings account balances. However, in government money market funds, the manager invests exclusively in US government securities, and the US government is the ultimate backstop for FDIC insurance as well. The current annual yield on our money market fund is just over 4.5% as of the end of last month. To put that in perspective, a $100,000 cash reserve using the annual average savings account interest rate(0.39%) would yield $390 in interest per year. That same amount invested in a money market fund at 4.5% would yield $4,500 in interest over the same time period. An easy adjustment of where you hold your cash reserve could result in a significant increase in interest with very little increase in risk.
Paying off Fixed Rate Mortgages
The decision to pay off your mortgage early is influenced by many factors – both quantitative and qualitative. As advisors, we are often asked to evaluate the quantitative side and weigh the alternatives of using extra cash to put towards savings, position towards investments in a portfolio, or pay down debt. A loan’s interest rate is a major part of the analysis as it provides the hurdle rate for that decision point. For example, if your mortgage rate was 5%, and you were using cash/investments to pay off the debt, you would want to compare the loan rate to current cash yields or the potential return on your investment. When you pay off the mortgage, you essentially lock in a return equal to the loan rate (in this instance, a 5% return). You don’t have to think very far back to when cash yields were basically non-existent, CD and bonds yields weren’t much better, and the outlook for the equity markets was quite grim. At that time, a 5% return on any investment was welcome.
In our current rate environment, the advice on whether to pay off existing fixed rate debt has turned a bit on its head. If you were lucky enough to secure a mortgage or re-finance when rates were in the 2.5-3.5% range for a 15 or 30 year fixed rate mortgage, you might consider maintaining the debt and earning more interest on your cash investments (such as the money market fund described earlier). In this instance, your cost of borrowing may only be 3%, while your money market fund is paying you 4.5%. Here, you can take advantage of the 1.5% rate arbitrage opportunity as your borrowing costs are lower than what you are getting paid for your cash-like investments.
Paying off Variable Loans
Unlike borrowers with a fixed rate loan, holders of variable rate loans, such as a home equity line of credit, have seen rates increase meaningfully over the last year. Home equity lines that started with 2.5-3% rates have jumped to more like 6.5-8%+ today. Adjustable rate mortgages (ARMs) nearing the end of their fixed rate period may also start to see an increase in rates. Keep in mind that many ARMs have caps on the annual increase in rates so evaluating the rate increase schedule in comparison to current rates is advisable before taking action. Still, it may be wise to convert a variable loan into a fixed loan or pay off the variable loan as soon as possible.