As you have probably seen through news headlines, the federal reserve announced a 0.75% interest rate hike earlier in June. This was the largest rate hike since 1994, and they are expected to continue to increase interest rates through the rest of 2022.
Before panicking, let’s get a clear understanding of what this means and how it will impact your financial plan. The federal reserve’s job is to make sure the US economy remains stable and does not get “too hot” or “too cold”. They do this through monetary policy, which means controlling the supply of money in the economy by increasing or decreasing interest rates.
When you hear people talking about the Federal Reserve increasing interest rates, they are referring to the Federal Funds Rate. The Federal Funds Rate is the interest rate that commercial banks use to borrow and lend money to each other overnight. This rate impacts other rates, such as the prime rate, which impacts all other interest rates in the economy (mortgages, car loans, credit cards, etc.).
When the Federal Funds Rate is increased, the goal is to increase the cost of borrowing money, and when it is decreased, the goal is to decrease the cost of borrowing money. When rates are increased, this could deter consumers or businesses from borrowing money. If a consumer is planning on buying a house, and the interest rate of a mortgage increases, this may make them wait until the rates go down to purchase the house. And if rates are low, borrowers may be more inclined to purchase the house because the cost of borrowing money is low (lower interest rate).
Higher interest rates also encourage people to save money (if the interest rate is higher on your savings account, it may lead you to save more), decreasing the amount of money that is in the economy.
Interest rates are generally raised to “cool” the economy, with the goal of lowering inflation and decreasing economic activity. On the flip side, interest rates are generally lowered to help stimulate the economy by encouraging increased economic activity.
So why has the federal reserve decided to raise interest rates recently? Their goal is to help lower inflation. The inflation rate hit 8.6% in May, so one of their goals is to “cool” the economy. If people are spending less, this should lead to the cost of goods decreasing, as demand also decreases.
How does this impact your financial plan?
The obvious answer is that it makes debt more expensive. Any loan that is locked into a fixed interest rate will not increase, but variable rates and new loans could now have higher interest rates. A rule of thumb we use is that if a loan is higher than what an equity portfolio has achieved historically (and not tax deductible), paying it off may be a priority depending on your situation. This is based on a conservative estimate that money invested in the market should average a rate of return higher than the debt over a long-time horizon (after taxes).
Other considerations should be given such as cash flow, month to month budget, and track for other goals such as college or building to financial independence.
Generally, EWA recommends maxing out tax efficient options like a 401(k), backdoor Roth IRA, mega backdoor Roth IRA, health savings account, 529 plans, etc. first.
Then if there is extra money, determine if it is better to pay off debt in an accelerated manner or save in a non-qualified brokerage account.
Do I save in a brokerage account after maxing out tax efficient options or pay extra into my mortgage?
2. Then assume that all short-term needs are taken care of, and instead of paying off the mortgage, an investor has the timeframe to put this extra money into a brokerage account (all equities) and assume to earn 7%. Assume this taxpayer is subject to a 23.8% federal capital gain rate.
In this example, it would be recommended to go with option 2 and save the money in a brokerage account given the higher tax adjusted return.
2. Then assume that all short-term needs are taken care of, and instead of paying off the student loans, an investor has the timeframe to put this extra money into a brokerage account (all equities) and assume to earn 7%. Assume this taxpayer is subject to a 23.8% federal capital gain rate.
In this example, it would be recommended to go with option 1 and pay extra into the student loans.
Here it is important to ensure that the borrower is not eligible for some kind of forgiveness before paying extra into the student loans if they are federal student loans.
Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.
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Past performance is no guarantee of future results. The change in investment value reflects the appreciation or depreciation due to price changes, plus any distributions and income earned during the report period, less any transaction costs, sales charges, or fees. Gain/loss and holding period information may not reflect adjustments required for tax reporting purposes. You should verify such information when calculating reportable gain or loss.
This content has been prepared for general information purposes only and is intended to provide a summary of the subject matter covered. It does not purport to be comprehensive or to give advice. The views expressed are the views of the writer at the time of issue and may change over time. This is not an offer document, and does not constitute an offer, invitation, investment advice or inducement to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any matter contained in this document. The tax and estate planning information provided is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
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