Will Lower Interest Rates Really Matter?

There’s been lots of talk that the Federal Reserve may start cutting interest rates this year. Maybe you’re thinking lower rates will be the break you need to buy that home or car. After all, when the Fed cuts rates, it makes borrowing cheaper to buy those things, and historically, it’s also boosted economic growth and the stock market.

Before you get too excited, a rate cut by the Fed this year is far from certain due to stubborn inflation. Also, if the Fed does cut its key lending rates, don’t assume it will cut them to near zero again as it did in its last two cutting cycles. That said, the interest rate picture may hold its share of opportunities, but they differ depending on your situation.

This time likely won’t be like last time

In late 2008, when the Fed cut rates to near zero the first time – and kept them there for seven years – it was in response to the global financial crisis. The second time was between 2020 through early 2022 in response to a global pandemic. This time, economic growth is on solid footing, and the Fed needs to ensure that inflation stays contained. So, in the current environment, it’s anybody’s guess how much the Fed will be willing to cut rates this year if it does at all.

The amount the Fed cuts rates will help determine the impact that lower rates will have on the economy and on your personal finances.

Keep in mind that while past performance doesn’t indicate future results, in the past 50 years, the economy and the market chugged along just fine when the Fed’s key rates were at similar levels.

They stand only a bit higher than their average over that period, so in the absence of a threat to economic growth, the Fed is not under pressure to cut very much. 

In the event the Fed does lower its rates, it will impact people differently, depending on their financial situation and life stage, and that impact includes opportunities as well as challenges. To illustrate this point, we look at three aspects of one’s finances: savings accounts, investment portfolios and home buying – and we bet at least one of them may be relevant to you.

Debt-free and not planning on borrowing? Lower interest rates still matter.

If you’re fully debt-free and don’t expect to borrow over the next couple of years, then lower rates are likely immaterial, at least from a borrowing perspective. However, that doesn’t mean lower rates won’t affect you.

Chances are you have cash reserves in the form of bank savings accounts, certificates of deposit or money market funds. CDs and money market funds have been offering the highest yields in more than a decade, thanks to the Fed’s rate hikes. The extra income has been a welcome benefit, especially if you’re retired.

However, yields will decline on those accounts if the Fed lowers rates.

If you’re in a one-year CD or shorter, and rates decline in the interim, you may have to reinvest at a lower rate soon.

That’s one of the reasons why you should not buy a CD purely based on yield. You need to consider a variety of other factors, including when you will need that cash.

While you may be tempted to lock in higher rates by investing in three- or five-year CDs, caveat emptor: It means you may not have access to the money over that multiyear period. Also, inflation and taxes eat away at the income these investments provide.

“Over time, investments such as CDs and money market funds can feel like less of an advantage due to inflation and taxes, regardless of the level of interest rates,” says planner Christopher Kenny, Director, Financial Planning. “This is the trade-off for managing risk. CDs and money market funds can be useful investments for the near term, but not a great solution for money needed further in the future.”

While past returns are no guarantee of future performance, returns of a diversified allocation of stocks and bonds have outpaced inflation over time.

We believe investing in a diversified portfolio versus CDs is a better long-term strategy to help achieve your retirement goals.

Regardless of the level of interest rates, we recommend cash reserves that will cover expenses anywhere between three and 24 months, depending on your circumstances and comfort level.

“Lower interest rates may have a negative impact on the income that their cash reserves may earn going forward,” says planner Ron Sisk, Executive Director, Financial Planning. “But this reason alone should not jeopardize the purpose of cash reserves, which is to maintain enough safe, liquid resources for an emergency or short-term need,” he says. 

What would rate cuts mean for your portfolio?

The stock market can price in its expectations of events well in advance. Its expectations for rate cuts have been no exception, with the S&P 500 hitting multiple record highs in the first few months of the year.

That is not to say that the stock market’s expectations are correct. Stocks could respond positively to more rate cuts and/or larger rate cuts than expected, and that could certainly benefit the portfolios of retirees and those saving for retirement.

Of course, there is no way to predict exactly what the Fed will do and trying to time the market based on a prediction could hurt and not help your portfolio’s returns.

By the same token, rate cuts could boost bond prices, which move in the opposite direction of their yields. While higher bond prices would help returns of diversified portfolios, lower yields would also mean bonds produce lower income. If you’re retired, you may have begun to enjoy any bond income brought about by the Fed’s rate hikes. However, if yields do fall, we design our diversified portfolios with total return – or the combination of income and growth – in mind, which is why staying invested is critical – regardless of the rate environment. 

“We take a total return, diversified portfolio approach to retirement income,” says Kenny. “Owning investments expected to appreciate over time alongside investments that pay fixed interest can help decrease your reliance on interest payments to cover an income need.” 

If you do have questions about your portfolio, always consult your planner. Regardless of whether the Fed cuts rates, there’s likely no reason to change your portfolio unless your financial situation or goals have changed.

Waiting for the Fed cuts to buy a home?

It’s important to note that the Fed only controls its key overnight lending rates, not the longer-term rates that govern mortgage loans. However, the Fed’s rates do influence the rates of consumer loans, like mortgages.

Before the Fed began hiking rates in 2022, mortgage rates had been historically low for more than a decade, with the average 30-year fixed mortgage running beneath 5% during that time. As mentioned, it is unlikely that the Fed will cut its key lending rate to near zero again, so don’t count on mortgage rates going back to their historic lows.

This may be a tough pill to swallow if you have a mortgage rate beneath 5% and need to buy a new home – a predicament that may be felt by people who are saving for retirement and have a growing family.

Talk with your planner about how to balance your need to save amid higher mortgage rates. 

Like the market, mortgage rates can price in rate expectations well before the Fed acts, so planner conversations need to happen sooner rather than later.

However, mortgage rates are just one factor in the decision to buy a home.

“You shouldn’t make a decision about when to purchase a home or car based purely upon what interest rates are,” says planner Jeffrey Whitmer, Director, Financial Planning. “It could mean finding a home in a slightly lower price range but shouldn’t necessarily prevent you from buying the home you need.” 

For context, mortgage rates today are not high by historical standards. Over the past 50 years, the average rate for a 30-year fixed mortgage has been between 7% and 8%.

IF THE FED CUTS RATES, YOUR DECISION TO REFINANCE MUST GO BEYOND THE 1% RULE

For those who bought homes in the last year and have a mortgage rate above 7%, you may be looking for an opportunity to refinance if the Fed cuts rates. Refinancing could make sense financially but it's far from a given due to the uncertainty around how much lower rates will go.

The rule of thumb: Refinancing makes sense once you can secure a mortgage rate that is one percentage point beneath your current rate. However, it’s much more complicated than that. A variety of factors need to be considered.

“The calculation for determining whether refinancing is worth it has to take into account many things well beyond closing costs,” says planner Dale Hansen, Director, Financial Planning. “How your tax deductions may change, if your savings will offset points paid on the original mortgage, how long you will stay in the home, will you need to change the duration of the mortgage and that’s just some of them.”

As always, consult with your planner who can help you with these considerations in the context of your overall financial plan.

Conclusion

Ultimately, it’s impossible to predict what the Fed will do. When looking at your finances over a multiyear horizon, lower rates may have an impact in the shorter term, but sticking to your financial plan is what will help you achieve your longer-term goals, whether you’re retired or saving for retirement.

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