Dubai: Interest rate hikes are looming worldwide as countries look to push past the economic effects of the pandemic and the resultant ultra-low-interest rate policies that are in place currently. Here’s how can you prepare your finances before that happens.
Even before the pandemic began, particularly during the past decade, interest rates have been so low it didn't matter what you did with your cash. There was a certain convenience to that — you didn't have to move money between savings and higher-rate accounts, because they paid almost the same.
Rates expected to rise in the coming months
However, to speed up post-pandemic economic recovery, interest rates are now expected to rise in the top economy, the US, after which more countries elsewhere will quickly following suit – as it has historically been the trend. But what does that mean for you as a borrower?
While rising interest rates means it costs more for you to borrow, it also can work in your favour. Here are a few examples of how interest rate hikes can benefit you financially.
Depositing more money into savings can benefit
Savings accounts have been at historically low interest rates in the past few years. While a hike in rates won't make you rich, it can give you a slight boost in your savings power, for no extra work.
As interest rates increase, now is a great time to start socking extra money away into savings accounts.
While putting extra money into savings might not result in as much interest earned from other saving avenues, such as retirement accounts or other investments, you can use the higher interest rates as an incentive to boost your savings or emergency fund contributions.
Take advantage of still low interest rates
After the financial crisis of 2007, lending came to a near halt and central banks worldwide drove interest rates to the floor.
Higher interest rates may make it more expensive for borrowers than over the past several years, but rates are still near historic lows.
While it's important to use caution when borrowing money, now might be the time to strike if you've been on the fence about making a big purchase, such as buying a home.
US rate hikes bring in forex, spending and savings benefits
With borders opening up – albeit at a slower rate, tourism and travelling is making a comeback, improving significantly since last year. As US interest rates rise, it could very likely strengthen the US dollar.
A stronger dollar means those travelling abroad can get a better exchange rate than usual. With exchange rates working in your favour, you can splurge a little bit more (or save more) than you had maybe originally budgeted for.
Pay off your debt now rather than after rates are hiked
The interest rates on your debt will rise if central banks continue to increase rates henceforth. This means you will be required to pay even more interest on your debt, owing more money overall.
You can lessen the blow by prioritising your debt repayment now. The sooner you pay off debt at a lower interest rate, the more money you will save. Use the risk of increasing rates to get your debt paid off as soon as possible.
Credit card debt is especially susceptible to climbing interest rates. Credit card debt has its own high interest rate, so any additional increase from central banks will only cost you more. Avoid paying extra interest by prioritising debt repayment today.
Consider refinancing your existing loans now
If you've been considering refinancing your home or auto loan, you may want to do it before central banks considers increasing rates. In addition, if you bought your home at a higher interest rate and have not yet considered refinancing, you may not be getting the best deal available.
Even if interest rates don't change again, you may still find it advantageous to refinance your mortgage or auto loan to a better rate.
Why keeping cash handy is vital, regardless of where interest rates are headed
Before we take a look at where you should be holding your money when interest rates are rising, let’s first revisit a few reasons why you need cash on hand regardless of the interest rates.
There are four main reasons to hold cash: liquidity balances, planned expenses, temporary holdings, and an emergency fund. The size of your temporary holdings may vary quite a bit from time to time, but the others have pretty specific parameters that it's worth being clear about.
• Liquid balances
Your income arrives as a lump sum on a date that doesn't match the due dates of your bills, so having liquid balances help. Having liquid balances simply means the cash you keep on hand to smooth your due payments, so that you can pay each bill when it's due and not when it’s late.
Sizing the cash demands of your liquidity balances is easy: It's the total of all the bills that might come due between income payments. Once you know this amount, you can set it aside for when you need it.
• Planned expenses
Everybody has some expenses that are not regular monthly bills, but are nevertheless known in advance. Some of these are regular, they're just not monthly: tax payments (if applicable), insurance premiums, tuition payments, etc.
Others are irregular, such as discretionary payments on things like home improvements, airfare for your vacation, buying a boat, etc. Regular or irregular, if there's a near-term payment to make, it's good money management to hold some cash to pay it.
• Temporary investments
Sometimes you have cash that you've decided to invest, but that you aren't ready to invest yet. Maybe you don't know exactly where the money should go until the next time you rebalance your investment portfolio.
Maybe you expect market conditions to improve. Maybe you're accumulating money to meet the minimum balance of some fund. Whatever the reason, until you're ready to invest, you're holding the money as cash.
Your emergency fund is cash set aside to handle a financial crisis — a job loss, a medical bill, a home repair, etc. Having the money on hand means that you won't have to turn to credit cards or other forms of debt to get through your emergency.
Experts often recommend an emergency cushion of three to six months' worth of daily living expenses. Your unique situation — such as an expensive medical condition or a high-paying job that would be difficult to replace — may call for a larger fund.
Where best to hold my cash when interest rates are rising? Let’s weigh our existing options!
There are a lot of different kinds of institutions that hold cash and a lot of different kinds of accounts available at one or another of those institutions.
Whatever sort of institution you choose, you still need to figure out what sorts of accounts to use for your cash. Here are the usual suspects.
• Savings or current accounts
For most people, a savings account is their main gateway into the banking system. Their salary is directly deposited into their savings account, and most of their bills are paid out of that account.
Back in the 1980s and 1990s, banks had to pay reasonably competitive interest rates to pull in money to support their (highly profitable) lending.
That became less and less true in the early twenty-first century, until the financial crisis put an end to it. At the moment, savings accounts pay so little interest worldwide that most often people use the account to just deposit money with no intention of growing it.
However, that doesn't mean you shouldn't have a savings account — it's just no longer where you should hold your liquid balances (explained above) or your cash to cover planned expenses (also explained above), until just a day or two before you need to make a payment.
But when you think about savings accounts nowadays, though, you're usually not thinking about a savings account at your local bank. You're thinking about an online or digital savings account.
• Online savings accounts
These are just ordinary savings accounts, except they're at a bank that offers a convenient web interface for moving money to and from your checking account. The money moves are typically done in two or three days. This is quick enough to make these accounts very useful as a place to hold your cash.
Unlike a lot of other kinds of financial accounts (where the terms and conditions vary in complex ways), the terms and conditions of digital savings accounts tend to be relatively standard, making it easy for savers to compare one account to another and pick the one that offers the best deal.
• Money market funds
Money funds are a legacy of 1970s interest rate regulations. They pool money from shareholders, invest it in short-term securities, and share the return.
These funds invest in short-term debt instruments, and they pay out earnings in the form of a dividend.
Because the funds just share whatever return they get, returns go up quickly when interest rates rise, unlike savings and money market accounts, where banks that already have your money won't raise rates until they have to.
Although very safe, investments in a money market fund are not guaranteed. In fact, one money market fund lost enough money during the 2007 financial crisis that it was unable to make investors whole.
There are a lot of other places you might hold cash for the short term: Cash management accounts (a money fund or money market account wrapped up inside a trading account), Certificates of Deposit (CDs), and government treasury bills (which are government debt instruments to finance government spending as an alternative to taxation).
It is no longer prudent to just keep your money in your savings account, which is the simplest version of cash management. Now that you can earn a return that's more than a fraction above zero or 1 per cent, you can manage your cash more actively.
The easiest version of active management is just to shift most of your liquid balances, near-term planned expenses, and temporary investments into some sort of higher-yield account.
When your salary (or any other income) arrives in your savings or current account, transfer most of it to your higher-yield account. Two or three days before your bills need to be paid, transfer the necessary amount of money back to your savings account.
If your finances are sufficiently under control, you can skip the step of having your income enter via your savings account only to be transferred to your higher-yield account.
Instead, you can arrange to have your direct deposit go straight into your high-yield account. That gets you earning your higher yield a couple of days earlier, and potentially cuts the number of transfers you need to make in half.
Especially for expenses with due dates that are well-known but further off than this month, it may make sense to do something with CDs or treasury bills.
It may be more convenient to keep your temporary investments closer to where the investments are going to be held — perhaps in a money market fund in the same family as the other mutual funds you hold, or one with your brokerage firm.
While the possibilities are more than a few, the time for just leaving your money idle in your savings account has ended.