Dropping interest rates: Here’s your game plan

This past September, the Federal Reserve lowered interest rates for the first time in four years, jump-starting what many people believe could be a lower rate environment that may continue into 2025.

Besides the daily movements in the stock market, there may be no other financial or economic metric that’s as widely reported upon as interest rates – as well as the predictions as to where they may go. And since the Fed cut, you’ve likely seen dozens of articles telling you what you should (or shouldn’t) do if rates continue to move lower.

But as an Edelman Financial Engines client, you know that there is no one-size-fits-all strategy when it comes to personal finance. Your situation and the goals you want to achieve are unique. If the Fed does continue to lower rates, the effects will vary for each individual based on their unique financial circumstances and stage of life, presenting both potential advantages and drawbacks.

That’s why it’s important to understand the effect that lower rates could have on some key aspects of your financial life – your portfolio, your savings, and your decision to buy or refinance a home.

First off, let’s start by level setting

Any discussion about modifying your financial plan must be grounded in reality. And the reality is, even if the Federal Reserve continues to lower rates, it’s unlikely that we will reenter an environment like the one we had between 2008 and 2015, and again between 2020 and 2022, when rates were close to zero.

In both those periods, the Fed adjusted their monetary policy in reaction to a crisis – the financial crisis in 2008 and the Covid pandemic in 2020 – to stimulate the economy. In addition, during both those periods, unlike the current environment, inflation was not a concern.

In fact, as counterintuitive as it sounds, it may be preferable to be in a low-rate environment opposed to a zero-rate environment, because if we’re in the latter, it may be in response to larger, macroeconomic issues.

So, even though how much the Fed is willing to cut rates is anybody’s guess, since the economy is in better shape than it was during those crisis periods, it’s unlikely that we’ll get back to zero.

Won’t buying or refinancing a house be a no-brainer? Maybe not.

For most Americans, purchasing a home represents their largest financial investment and long-term obligation, with changes in interest rates having a more profound impact on this aspect of their financial lives than almost any other.

Refinancing can be beneficial when rates fall, but it’s essential to analyze the break-even period and not base the decision solely on interest rates.

However, in a changing interest rate environment, people often view purchasing and refinancing decisions through a lens that overemphasizes the importance of those rates. If you take this approach, it may lead to missed opportunities or rushed decisions that may not align with your overall financial goals.

Some individuals may even attempt to “game” the interest rate market, essentially trying to time it. But just like trying to time the stock market, this usually leads to suboptimal outcomes, and there may be better strategies.

As Jeffrey Whitmer, Director, Financial Planning at Edelman Financial Engines, wisely notes, "You shouldn't make a decision about when to purchase a home or car based purely upon what interest rates are. It may mean having to find a home in a slightly lower price range, but that does not prevent you from buying the home you need."

Thinking of refinancing? Make sure the numbers work.

Refinancing can be an attractive option when rates fall, but it requires careful analysis of several factors. The rule of thumb is that refinancing makes sense when you can lower your interest rate to at least 1%.

However, the decision to refinance should not be based on interest rates alone. Other important considerations include the break-even period – the time it takes for the savings from lower payments to cover the costs associated with refinancing, such as closing fees.

For example, if refinancing would save you $200 a month on your mortgage but closing costs are $6,000, the break-even period would be 30 months. If you plan to stay in your home beyond this period, refinancing could be a smart move. But, if you're unsure about your future plans or expect to move in the next few years, the upfront costs of refinancing may not be worth the short-term savings.

Should lower rates change how you save?

No matter what rates do, it's essential to maintain sufficient cash reserves to cover your expenses for a period ranging from six to 24 months, based on your individual financial situation. And if you currently have cash reserves in high-yield saving accounts, certificates of deposit and money market funds, you may be enjoying some of the highest yields we’ve seen in decades.

However, if interest rates fall, the yields in these instruments will also likely fall. And that might tempt you to try and capture a higher rate of interest by swapping out a shorter dated product like a one-year CD for a three- or five-year CD. But again, viewing your savings strategy solely through an interest rate lens misses the point.

Although it’s preferable to maximize the interest rate on your cash reserves when it makes sense, the main purpose of your cash reserves is not to generate income, it’s to maintain enough liquid resources for an emergency or your short-term needs.

How could lower rates impact your portfolio?

The stock market is generally considered a forward-looking mechanism, with investors putting money to work today in anticipation of how economic conditions might unfold in the future. This anticipatory nature means that the market often reacts to expected changes in economic growth, corporate earnings, and, of course, interest rates.

There is no one size fits all' strategy in personal finance. The effects of lower interest rates will vary for each individual based on their unique financial circumstances and goals.

That could mean that the stock market moves higher if rates go lower – and as long as expectations for even lower rates persist. And if stocks move higher, that would mean that bonds would move lower, right?

Not necessarily.

At times, there is a negative correlation between stock and bonds – when one moves higher, the other moves lower, and vice versa. But there have been other times when the correlation between stocks and bonds has actually been positive in a low-rate environment.

So, if rates do continue to go lower, what changes should you make to your portfolio?

As an Edelman Financial Engines client, you undoubtedly know that this is a trick question.

That’s because we take a total return, diversified approach to portfolio management. Which means that interest rates are just one of many factors we consider when building your investment portfolio. And that means that no matter what the Fed does, there is likely no need to change your portfolio unless your life or your goals change.

Focus on long-term goals, not short-term rates

Despite what the financial pundits and market gurus claim, nobody can predict what the Fed will do. And while nobody likes uncertainty, you can rest assured knowing that you and your planner have developed a comprehensive financial plan, one designed to navigate various interest rate scenarios, both high and low.

While short-term fluctuations in interest rates may have immediate effects, it's crucial to remember that adhering to your long-term financial strategy is key to achieving your objectives. This holds true whether you're currently in retirement or still in the accumulation phase of your financial journey.

And as always, if you have questions about the impact of changing interest rates, or anything related to your financial well-being, reach out to your planner. We’re here to help.