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Some rules of thumb with high interest rates

By September 8, 2023 No Comments

Interest rates are at their highest levels in 15 years. Many people have never earned disposable income in an economy like this. So it’s important to know what to do with the money you’re making. Just as the low interest environment of the 2010’s lasted longer than anyone predicted, the opposite may happen now; we could have high interest rates for a very long time. The old rules of low interest rates encouraged risk-taking and spending. The new rules of high interest rates encourage prudence and cash flow management. Let’s talk about some of the new rules for this new regime we find ourselves in.

First, pay yourself

If you’re still earning 0% in a savings account from one of the major banks then you’re scamming yourself. FDIC insured banks like Discover, American Express, and Capital One, are all paying interest of 4% or more on savings accounts. By comparison, JP Morgan, the largest bank by deposits, is paying 0.01% on savings!

Look at the monthly earnings of $100,000 saved in an account earning 4% interest vs 0.01% interest:

Interest Rate4.00%0.01%
Interest Earned$333$1

On a yearly basis, this equates to a difference of $4,000 in interest earned vs $12!

You are effectively paying a $3,988 yearly subscription fee by leaving your money in a super low interest bearing account. That amount could cover a monthly mortgage payment, go towards yearly property taxes, or pay for an awesome vacation. Stop paying the bank and start paying yourself.

Here are links to high yield savings accounts that are FDIC insured and paying more than 4%:

American Express
Capital One

Understand your cost of debt

If you have a mortgage rate under 3% you should not be putting a single dollar towards extra mortgage payments. Why not? Because you could instead earn more than 5% on that extra dollar with zero risk. One month to two year Treasuries are paying between 5-5.55% in interest. Best of all, these Treasuries are exempt from state taxes. So even if you’re in the 37% federal tax bracket, you’re after-tax return on a treasury at these rates is above 3%. If you’re in the 12-22% tax bracket (most common) your after tax return on these Treasuries is nearly 4% or higher.

Extra money paid on a mortgage is extra money you could have earned interest on. Granted, there are some emotional reasons someone may want to pay off their mortgage. However, in the current interest rate environment, for someone with a low mortgage rate, the math is agains their emotional argument.

Remember this simple rule: don’t be in a hurry to pay down debt if the interest rate you can earn is higher than the interest rate you will pay.

Think of utility over performance

There is tremendous utility available now that long-term interest rates have risen above 4%. Consider an example of a wealthy household who wants a low risk, tax-advantaged way, to save for their child’s education. This couple can “superfund” a 529 plan with $170,000 in 2023 without any gift tax implications.

They could then take that $170,000 and buy a 10-year treasury bond, currently yielding 4.25%. Assuming they reinvested the interest each year, they would have around $260,000 in the account at the end of 10 years. Best of all, the $90,000 in earnings would have been tax-sheltered.

Of course, this couple could choose different investments, like stocks, that would have the chance to do better than the 4.25% they earned on their bond. But there’s no guarantee such a choice would produce better results. The new regime of high interest rates means there is competition for your money. When rates were zero, you had to take greater risk to try and get your returns. Now, you don’t have to take much risk at all to be able to target certain returns.

This has great financial planning ramifications and increases the utility value of your money.

Watch that credit card spending

We’ve highlighted some ways you can benefit from higher rates, but you also have to be aware of the downside too. The average interest rate charged by credit card companies has climbed to 22% today from 16% two years ago. That means you’re paying $6 more in interest per $100 in debt on you credit card than you were in 2021.

For people with various debt amounts, such as student loans, car loan, and/or credit card, your credit card interest rate is likely the highest of the bunch. So, if you can only afford to pay down one debt load at a time, you may want to choose the one with the highest interest rate.

In addition, high interest rates on credit cards make it more important to only spend within your means. Gone are the days of the 0%, 15-month introductory APR and 0% balance transfers. Credit card companies have cut back on those offerings after doing huge promotions the last few years.

The new interest rate environment means new rules for investors and consumers alike. You should be earning a minimum of 4% interest on your savings. You also shouldn’t be in a hurry to pay down low-interest debt. Higher long-term interest rates means competition for your money, and lower-risk investments should be utilized effectively. Lastly, higher interest rates mean you need to be more careful with your spending and big purchase decisions. These are some of the new rules for the new economy.

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