If you have followed any news headlines this year in 2022, when we’re filming this video, rising interest rates are a concern for a lot of people. And we’ll be on many headlines as Federal Reserve has already raised rates throughout this year and they’re expected to raise rates throughout the rest of 2022.
Important to understand what that means and how that will actually impact your financial plan moving forward, so you don’t get distracted by all the negative headlines, completely normal to read those headlines and immediately think the worst and that your financial plan is in jeopardy.
But we’re going to go through everything you need to know about what rising interest rates mean and if and how it would impact your financial plan. So when you hear about rising interest rates, they are talking about the federal funds rate.
And the federal funds rate is the rate that the Federal Reserve sets, which is what banks charge each other to lend money back and forth. So the goal now of why interest rates are rising is to tame inflation.
Right now, inflation has hit a 40 year high. The last CPI was over 9%. The Federal Reserve raises interest rates. That means money is more expensive. People start to second guess taking out mortgages, taking out car loans, and the goal is to cool off the economy.
Versus the flip side, if interest rates are dropped, lending is a lot easier. If an interest rate is 1%, you’re more likely to take out a mortgage versus if the interest rate is 10%. So the first thing is people begin to rethink their purchases and spending money.
But right now, with inflation being at a 40 year high, the goal of the Federal Reserve is to help tame inflation and get people to stop spending as much money so that inflation begins to come down. So for financial planning, the first obvious thing is that debt becomes more expensive.
So we always want to make sure that no matter what, the first thing is that we’re maxing out all tax favorite accounts. It. So the first one would be taking advantage of maxing out your four hundred and one K.
Second thing would be backdoor. Roth IRA. Third thing would be if you’re saving for education, 529 plans. And and then fourth in no order because HSAs actually are the most tax beneficial. But health savings accounts, all of these things, no matter what interest rates are and no matter what’s going on, I want to make sure we’re checking that box first.
So now it comes down to we’re maxing all these accounts because all of these have tax favored. Second question becomes do we save into a taxable investment account versus paying off debt? First thing we want to look at is what kind of debt do you have?
So if you have a mortgage, say interest rate has gone up to 5%, which right now as we film this video, it has gone up to about 5%. The first $750,000 on a mortgage is always tax deductible. You can deduct the interest that year.
So if you have a $1.5 million mortgage, that 1st 750 is deductible every year. So a 5% mortgage, assuming you’re in the highest tax bracket of 37%, that’s actually an effective interest rate of 3.15% and what you’re paying on that debt.
So 5% mortgage seems really high. But once we factor in the tax deduction, that’s a pretty favorable interest rate. So now we want to compare that to do we want to pay that off or do we want to invest the money in a taxable investment account?
So historically the S and P 500 has returned about ten and a half percent. But a diversified portfolio, if we want to be super conservative, will average a. 7% rate of return, 23.8% capital gains. On any long term growth.
So effectively, after taxes that would be a 5.34% rate of return earn. So obviously in this scenario, we would recommend let’s invest into a taxable investment account versus aggressively paying off the mortgage.
So we look long term over a 30 year period. Assuming you’re in a 30 year mortgage at 5%, $750,000 is going to be about $4,026 per month with interest and principal after that 30 years to pay the mortgage off, you’re going to pay almost $1.5 million into that mortgage versus on the taxable account after taxes.
If we assume a 5.34% rate of return every year and we take that. Same monthly contribution just to give an. Apples to apples comparison, we invested that. Into the taxable investment account every month.
For 30 years, you’d be left with. About three and a half million dollars. So over double your money, making it. Much more advantageous to invest in the. Taxable account versus paying off a low. Interest tax deductible mortgage.
So other example of paying off debt, so mortgage is tax deductible. If you have student loan debt that is not tax deductible. And this would be assuming that you are not eligible for any sort of loan forgiveness with public service loan forgiveness where you would not want to pay the debt off aggressively.
Same situation. Student loans, let’s say average 6.8% federal loans, or if you refinance right now, probably would be 5% or 6% given. The higher interest rates anyway. So 6.8%, no tax deduction versus investing in a taxable investment account after taxes, assuming 7% rate return of 5.33 4%.
In this scenario we would recommend let’s aggressively pay. Student loans. We still may invest some into the taxable account, but we would want to pay more than the minimum to try to get these knocked out faster than, let’s say, the average ten year period.
Important to not freak out if you read headlines about rising interest rates, and most likely it depends on your situation, depending on if you have debt that is tax deductible or not tax deductible, and what the interest rate on the debt is, most likely it will not have a significant impact on your overall financial plan.
But important to talk to a financial advisor to analyze your specific situation, and we’re happy to help if you have any questions.