Most economists maintain that we are in recession. While we appear to be less affected in the State of Texas than elsewhere in the country, there are clearly signs of a slower economy such as layoffs, falling home prices, delayed or canceled commercial construction projects, etc…. The slowdown has been so extreme nationally that the federal government has taken unprecedented steps to reverse the conditions. One of these has been the aggressive use of monetary policy, including the reduction of interest rates. The current federal funds rate - the interest rate at which private depositary institutions lend money (federal funds) at the Federal Reserve to other depository institutions – is a mere 0.25%, or one-quarter of one percent. This is the lowest rate since 1954.*
This action is designed to encourage banks to lend money again and for consumers to spend, so money begins to flow through our economy again. The federal funds rate not only gives us a benchmark for rates on consumer borrowing, but also for interest on deposits and other government-backed investments such as treasuries.
The GOOD part about these lower interest rates is that it becomes cheaper for the consumer to borrow. Often the largest single interest bill that consumers pay is on their home mortgage. The national overnight average for a 30-year fixed mortgage is at 5.11 percent, according to bankrate.com. This can provide new home buyers a much more affordable loan and current homeowners an opportunity to refinance their current mortgage to save a substantial amount of money over the term of their loan. Of course, rates vary with the type of loan obtained such as a fixed or adjustable rate, and this really depends on how long you intend on staying in your home.
What should new home buyers be aware of in purchasing a new home? “Credit score is the number one factor in your ability to obtain a home loan,” says Houston Morford, of Southwest Bank mortgage here in West Lake Hills. You’ll need a credit score above 640 at most mortgage companies in order to even consider your loan application, along with liquidity for a down payment. (In this economy, 100 percent financing is generally a thing of the past). Morford says that better rates are obtained with 10-20 percent of the price of the home paid at closing, while some of the best rates may be obtained with a 40 percent down payment. He also recommends consulting www.freecreditreport.com to obtain your credit score. For $5 a month they will notify you of any inquiries to your credit to any of the three credit reporting agencies. This may provide protection against identity theft.
What about refinancing? There are a variety of reasons you may want to refinance your home, from debt consolidation to college funding to starting a new business. Debt consolidation is another good opportunity that may be reaped from lower interest rates, especially when credit card rates may exceed 20 percent or more! This can be done using home equity as well. The general rule for refinancing your mortgage, according to Morford, is make sure that the closing costs can be repaid by the savings obtained with the new loan while you are still living in your home. There are many websites with calculators to help you make the decision to refinance, but here is one you may use: http://www.bmcloans.com/calculators.asp.
Unfortunately, for investors looking for interest bearing investments, there is a BAD side to low interest rates. One of these is found in “interest rate risk.” Interest rate risk is the risk, or variability in value, inherent in an interest bearing asset such as a Certificate of Deposit (CD), or bond due to changing interest rates. In general, as rates fall, the price of a fixed bond will rise, and vice-versa. CDs, treasury bills bonds and other fixed-income investments pay a fixed-rate of interest for a certain term, after which the principal is returned. These instruments are bought by risk-averse investors, those simply seeking a safer return on a portion of their investments as part of an overall asset allocation strategy, or those simply needing income. The problem today is that interest rates have declined to lows we haven’t seen in decades, and these are reflected in rates paid by these types of instruments. With the federal funds rate at 0.25%, there’s not much lower rates can go. The next move may be up, even if it may not happen for a year or more. So, the interest rate risk these days is the fact you lock in a low rate for a specified term, and then rates rise during that term. You’re then stuck with the lower rate.
How do fixed-income investors achieve a respectable rate of return without experiencing the higher risk associated with the fluctuation of interest rates? Laddering involves building a portfolio of bonds with staggered maturities so that a portion of the portfolio will mature each year. To maintain the ladder, money that comes in from currently maturing bonds is typically invested in bonds with longer maturities within the range of the bond ladder. This accomplishes two goals: 1) It allows the investor to capture price appreciation as the bonds age and their remaining life shortens; and, 2) Reinvests the principal from maturing short-term (hence lower-yielding) CDs or bonds into new longer-term (hence higher-yielding) CDs or bonds. Another strategy is the “bullet” strategy. With this strategy, you purchase bonds at different times to reduce the interest rate risk, so they all mature at the same time. But where you put your money while you’re waiting is the problem.
This gets us to the truly UGLY part of low interest rates. The lowest interest rates for investment are found in money market accounts and in shorter maturity CDs, treasuries and bonds. A sampling of the rates on January 9th via bankrate.com shows taxable mutual fund money market rates ranging from 0.56 percent to 1.81 percent and 1 year CD rates ranging from 1.35 percent to 3.39 percent. 1 year treasury bills are yielding a mere 0.43 percent! Despite the safety and liquidity of these investments, investors using these in taxable accounts are potentially losing money at these rates due to taxes and inflation. For example, with inflation currently at an estimated 1.07 percent,** an investor in the 30 percent tax bracket (married, filing jointly) earning 1.5 percent on $10,000 in a money market, will actually have a negative 0.02% rate of return. In other words, you’ll have about $999 after one year, considering taxes and inflation, so you lose one dollar.. The same investor earning 3 percent in a one-year CD for $25,000, will earn a whopping 1.03 percent, or about $258 dollars.***
So what can you do? Well, you’ll have to consider longer term investments where appropriate, and consider laddering and bullet strategies discussed above. For money that you want to retain in safer fixed-income investments (vs. stocks) but don’t need the liquidity, consider intermediate and high-yield corporate bonds. There are quality bonds yielding 8-10 percent compared with 10 year treasuries yielding 2-2.25 percent. Also consider municipal bonds, but be careful to only buy the municipals with solid fundamentals and those that are insured. Many higher-rated municipals have lost value due to the economy. If you can handle the added risk, consider higher yield stocks in blue chip corporations or mutual funds/ETFs that invest in a basket of these.
Use this low interest rate environment as an opportunity to lock in lower borrowing rates to save money over the long term. Remember that there is a price to be paid for the safety of lower yield investments. With corporate bonds, municipal bonds and stocks offering compelling values, reconsider how much more risk you are really adding by investing in these instruments.
Brent T. Beesley, CRFA™
Eltekon Financial, LLC
Principal/Director of Private Wealth Management
Investment Advisor
100 Congress Avenue, Suite 250
Austin, TX 78701
512-477-3200 ofc
512-477-3201 fax
www.eltekon.com
* Yahoo News, December 14, 2008.
** InflationData.com
*** Real rates obtained using iLoancalc at www.iloancalculator.com