Though Polonius may have advised his son, “Neither a borrower nor a lender be” (Hamlet, Act 1, Scene 3), that’s pretty much an impossible goal in today’s financial world. Throughout the various stages of our financial journey, most of us are either a borrower or a lender—and sometimes we’re both, simultaneously. Another well-known aphorism that rings true in this connection is, “One person’s medicine is another person’s poison.” We all deal with interest rates in various ways: in the interest we pay to mortgage lenders or credit card companies; in the interest we collect from our fixed-income and other interest-bearing investments. The difference—both in the effect of interest rates on our financial situation and our attitude toward them—is largely determined by which side of the interest rate transaction we happen to be on.
Starting Out, Paying Out
For most young people at the beginning of their careers and families, interest is something you pay. Buying a first home, financing a needed vehicle, making student loan payments, dealing with credit cards, and perhaps even launching a business using leverage are all ways of borrowing and thus becoming responsible for servicing that debt by making payments that include interest. When you’re in this stage of life and interest rates go up, it can create strains on your cash flow, including your ability to save and invest. When rates fall, young people can benefit from lower payments on debt, making it easier to save for important goals like purchasing a first home or perhaps building an education fund for a child. At this stage, the most important financial planning focus should be on budgeting, which should ideally include deposits into a liquid emergency fund (to help avoid the necessity for incurring credit card debt) and savings. Perhaps the best way to make interest rates work for you at this stage is participating in an employer-sponsored retirement plan, such as a 401(k) or 403(b). When you’re young and you have decades ahead of you, even modest amounts tucked away into an account that can grow and compound without being taxed can add up to a major head start on a financially secure retirement.
Mid-Career, Building Up
As the years pass and your income trends upward, interest rates can take on more of a mixed meaning. You are likely still paying on a mortgage, but you are less likely to be carrying significant levels of other types of debt, such as credit cards and student loans. In fact, you may be starting to see significant growth in your tax-advantaged retirement accounts and your savings and investments. As you build wealth, you may also be funding education accounts for children. When rates go up, you may benefit by receiving better returns on the fixed-income portion of your investments (interest-bearing accounts, bond funds, and others). When rates fall, you may be able to refinance mortgage debt to achieve lower house payments or, in the case of a cash-out refinancing, utilize a portion of the equity in your home for other important purposes, such as home improvement or higher education funding. During this stage, your most important financial planning focus may be maximizing your retirement savings and reviewing your investment asset mix for the proper balance between growth and stability (diversification).
Nearing or in Retirement: Cashing In
Persons who have mostly or entirely completed the “accumulation” phase of life and are entering the “preservation and income” phase typically have the least debt; they are more likely to be on the “receiving” end of interest rates, in the form of payments into their accounts from fixed-income investments and interest-bearing accounts. Still, when interest rates rise, they are likely to see the value of their existing fixed-income holdings (mutual funds invested in bonds, for example) fall. On the other hand, rising rates may also mean that they are able to increase levels of income received from interest-bearing holdings like bank certificates of deposit or high-interest savings accounts. It may still be important for them to maintain a portion of their investable assets in stocks or equity mutual funds, since these types of assets can often benefit from falling interest rates and can also generate growth in order to preserve purchasing power in the face of inflation. During this stage, the financial planning focus shifts back to budgeting (ensuring that the income available from all sources is sufficient to meet the expenses of retirement) along with attention to proper diversification, “drawdown” strategy, and investment management.
At The Planning Center, we work with clients in all stages of the financial life cycle. By building financial strategies that take into account our clients’ most important goals, available resources, and tolerance for risk, we can provide a “road map” for the financial journey. To learn more, please visit our website and read our article, “Financial Strategies for Growing Families.”
