When Interest Rates Rise

Chapter 2

 

Why Interest Rates?

Why interest rates? The impact from interest rates has never before been so important to personal finance, for your wealth generation and wealth preservation. If the housing and financial crisis were not enough to scare you, well there is another chapter to this story. Unprecedented events have occurred that have created mindsets that may not be suited for what is to come and what will be.

A rising interest rate will have profound effects on fixed income markets and major points within personal finance. It is knowledge on interest rates that will keep your outcome different from that of Nick, Michael, or Betsy. Their life stories will be at the mercy of interest rates effects.

The group, that is Nick, Michael, and Betsy, never had interest rate discussions when personal finance conversations occurred. When reflecting back at conversations with financial planners, friends, and family, if interest rates were discussed, it was only about their current level. There was no discussion on longer term trends and impacts to their life of finances. Their life lessons will help you look at interest rates from a different perspective and give you the knowledge to process information differently. No one is more concerned about you, than you. Definitely an egoism perspective here, but a real one.

Michael was an avid Nicholas Cage fan. He was a big enough spender to have scored a few autographed pictures of Nicholas Cage, which were present on the entrance to his home theater. We will later find out, but there is a little irony with this, as Nicholas Cage, fell asleep with his personal finances and eroded his wealth. You could erode your wealth, unknowingly, like Nicholas Cage if interest rates are not considered in your personal financial planning. The goal here is to grow and protect your hard-earned money and not have it vanish.

Here is the story on Nicolas Cage. He made a fortune from the movies like, “Gone in 60 Seconds” and “National Treasure.” From 1996 to 2011 Nicolas Cage would earn over $150 million dollars. Lavish spending and no oversight or accountability to his financial managers cost him to lose all that money and owe the IRS millions of dollars. A lot of people would get caught in bad economic times and experience wealth or financial hardship from lack of awareness. Celebrities would get got caught too, Nicolas Cage purchased a 28-room castle which sits on 395 acres of forest in 2007. Talk about a money pit and bad timing, no pun intended.

Most of us will never have that kind of money but we can do a much better job hanging on to our money and investing it. Debt avoidance and capital preservation are key concepts to personal finance. Betsy had no debt and before retiring, she had her home paid off in full. Financial freedom is what Betsy had, no debts, and a livable stream of money from her investments.

The entire group, Nick, Mike, and Betsy, all had perceptions of personal finance that were formed due to a long trend in the interest rate. Little focus is spent on the trend of the interest rate as it moves very quietly over all aspects of personal finance. For example, how often do you look at stock tickers or your investment account balances… in a day, a week, a month? You most certainly are looking at your investment account balances more times than you are looking at interest rates, let alone changes in interest rates from a previous point, or historical trend.

Even though we don’t spend as much, if any, time looking at interest rates, we know that interest rates have an effect on all investments and are a component variable in all loan types. Sometimes interest rates are not viewed as something that may change. This is because interest rates generally change slowly and people view them as something they cannot control. This results in most dismissing their importance or impact to personal finance.

Take for example, when Michael purchased his BMW M3 series. It wasn’t the interest rate that Michael was looking at, it was the payment. Simply, could he afford the monthly payment? Most people, including Michael, that have a car loan, will not be able to tell you the interest rate on their loan.

Most people don’t dissect a payment into principal and interest. The interest rate really only becomes visible to the buyer when there is an interest rate change. An example of this would be if Michael went to the car dealer today to price out his M3 with options. He would think about these options and return a few weeks later. To his disbelief, the monthly payment was increased by $30 dollars from what he was originally quoted. The dealer would tell Michael that the interest rate had changed.

As you can see, it wasn’t the size of the interest rate that was impactful, rather it is the speed at which the interest rate changed, that would get his attention. Meaning we often don’t pay attention to the interest rate unless its alarmingly different at the point of transaction, for the better or worse.

Take Nick for example, he was only concerned with the change in the mortgage payment, not necessarily why. The root cause of the payment change, that is the interest rate, still isn’t a variable that Nick is conditioned to look at.

When interest rates are lowering, from a loan perspective, the effects of interest rate change often go unnoticed. This is because the next time a loan resets or a new loan is obtained, the interest rate terms are always better.

Let’s take a different perspective, that’s from the position of receiving interest versus paying it. When interest rates are lowering, you will get a little less income from your investments than you would at higher interest rates. This is often tolerated because the value of the asset is increasing.

This is the exact case for Betsy. She would have all interest deposited direct into her checking account. She was most aware that her income is lower than what she had gotten in the past but was accepting of this because her investment account was growing. At the moment, she isn’t aware that these effects are due to the interest rate.

The benefits we have seen from long durations of consecutive interest rate decreases has shaped the way we look at personal finance. In short, it has caused Nick, Michael, and Betsy to grow complacent. Just like through time, a house cat loses the skill of hunting and interpreting the environment around them. These lower interest rates we have experienced are not from normal market forces, albeit from unlikely events. Nonetheless, prolonged lowering of interest rates may cause us to make drastic mistakes within our decisions in all aspects of personal finance. These mistakes are based on real learned assumptions that are likely to never occur again in our lifetimes. Nick, Michael, and Betsy are all catastrophes from this conditioning.

We must understand that changing interest rates are not a bad thing. They are constantly changing, what makes the changes good depends on how you are positioned or exposed. Nick, Michael, and Betsy could have prevented their personal finance outcomes, provided they had awareness around interest rates. It is like a fire, useful and beneficial, but when certain elements occur, like high wind, lighter fluid, or some dried out pine needles, something useful can end up burning a city to the ground. Understanding interest rates and their movements will help you look at interest rates like a campfire and avoid a forest fire.

When we talked about long trends in lowering interest rates, it is actually surprising that it was 34 years in length. That’s correct, 34 years of lowering interest rates. There is a learned perspective that occurs over the course of 34 years. Over this length of time, it is only logical that you may view certain investments moving in a direction by a force that is something other than a reflection of interest rate changes. Nick, Michael, and Betsy all fell into this trap of conditioning. Betsy truly believes that her bond fund only goes up in value. She believes this because she has seen it and lived it. Everything goes up in value through time, right? Wrong.

Considering that most scholars on topic of habit formation say that it takes anywhere from 21 days to 6 months to convert something to habit. It may be logical that it takes relatively the same length to form assumptions based on past performance. Thus, we can all agree that over the course of 34 years some assumptions would have made their way to hard fact. The key wording here is that a trend is not a fact but rather a temporary state, that could eventually change. If you were paying attention to housing during the years prior to the burst in 2007, you may remember some not so key advice that you likely received.

Nick was at a friend’s house watching the Superbowl. This was the kind of gathering where there were friends of friends. Early in the night he ran...