How Rising Interest Rates Affect Your Investment for Early Retirement

interest rates

So what does it mean to you personally when the Federal Reserve raises interest rates? The latest consumer price index or CPI showed that our inflation is up 9.1% from June 2021 to June 2022, and it increased by 1.3% in June on a seasonally adjusted basis after rising 1% in May, according to the US Bureau of Labor Statistics.

The Fed Is Raising Interest Rates

The inflation rate at 9.1% is the fastest inflation pace going back to November 1981, and I wasn’t even born back then so this is the first time in my life experiencing what my parents experienced back in the 70s and 80s. And most of you guys reading this article never heard of this inflation problem before because our inflation rate for the past 40 years has been on average 2.5 to 3% annually.

The Fed Is Raising Interest Rates

Energy prices are up over 40% year-over-year and gasoline is up 60%. We are now paying so much more in gas, food, utilities, clothes, transportation, medical services, and so many more. While high inflation is happening not just in the US but across the world due to a geopolitical crisis in eastern Europe that’s creating supply chain issues, people are still spending a lot of money on things like airfares, gas, home improvements, entertainment, and buying cars.

June’s inflation rate at 9.1% might not be the end of it. People like to travel and spend money, especially during the summer months from July to September. So I wouldn’t be surprised if we see another increase in inflation in the coming months. I can’t say for certain we’re in a recession right now until we get the Q2 GDP report, but the Federal Reserve Bank of Atlanta’s GDP.

Now is projecting the Q2 GDP to contract by a negative 1.2%. Since Q1 was negative 1.4%, then two consecutive quarters of negative GDP would officially put us in a recession. What’s interesting about this potential recession is that our unemployment rate is still low at 3.6% as of June 2022. And job cuts are already happening right now, especially in the finance, tech, and bank sectors like Coinbase, Netflix, Tesla, and JPMorgan Chase.

I wouldn’t be surprised if the unemployment rate starts to rise to go into Q3 and Q4 of 2022. Many economists are now saying that this might be the beginning of stagflation like in the 1970s when our economy was going through a combination of high inflation, economic stagnation, and high unemployment.

So, for example, if we see a 7% inflation rate and 7% unemployment rate then it would be a kind of stagflation. And now what the Federal Reserve can do is calm inflation down by raising interest rates, which will most likely trigger a further recession going into Q3 and Q4 that will slow the growth of our economy in 2022.

When the economy slows down, we’re gonna see more job cuts from almost every sector because they’re gonna need to cut costs to maintain a certain profit margin, and then we could see a potential deflation that would be far worse than inflation.

I’m not trying to put fear in you but I want you to be informed about what could potentially happen to our economy with Fed raising interest rates in the near future. So in this article, I’m gonna talk about how the Fed raising interest rates could affect you personally with investing, debt, home buying, and saving cash. I also wanna go over briefly how you can prepare yourself for an economic recession.

For investors

So first let’s talk about investing in the stock market. The stock market in 2022 hasn’t been kind to us. As interest rates rise, people are going to spend less money on discretionary items. Companies are going to report disappointing earnings, and then naturally hedge funds on Wall Street are going to sell out their shares.

Whenever you see this major volatility in the stock market, it’s not retail investors like you and me making the stock prices move. It’s the large hedge funds that hold billions of dollars in stocks. When Fed raises interest rates, it’s going to make borrowing money more expensive for businesses.

As demand slows, that means more businesses could have lower revenues and net earnings which could impact their growth and stock values in the short term. Some smaller companies might even go under and file bankruptcies. We’re also seeing a lot of pain in the crypto market right now, especially after the disaster with Three Arrows Capital that led to the bankruptcy filing by Voyager Digital.

For investors

Something else I want to show you is the margin debt. This chart from Yardeni Research just came out on July 14 the day before I’m writing this article. Margin debt is down to almost at the 2020 level. As interest rates rise, more people are most likely going to get out of the margin debt because they’re typically in variable rates like credit cards, not to mention they’re not making any gains in the market right now, right?

If you don’t know what a margin debt is, it’s essentially investors borrowing money from their brokers to invest in stocks, bonds, crypto, or other securities. If you go to any broker websites like Fidelity which I’m gonna show you right here, they’re gonna show you the current margin interest rates.

For investors

So about the first half of 2022, people were getting margin calls. demonstration A margin call is when you borrow from your broker to invest and let’s say $10,000 to invest in a stock in January 2022. If that stock drops 25, 30, or 40% and it really depends on each broker’s maintenance requirement, then the broker can say “hey I need you to pay back some of that loan you borrowed because you lost value in that stock, or you’re gonna have to sell some other stocks to pay back the loan.”

And then the borrower says “oh crap I don’t have enough cash to pay back the loan because all of my stocks are down.” And then the broker can say “well if you can’t pay back the loan, I’m gonna go into your portfolio to sell some of your stocks to get our money back.” Ok, so that was probably the simplest way to explain a margin call, but just imagine billions of dollars got margin calls because most stocks are down 40, 50, 60, or even 80% for the year.

Margin calls are not the root cause but it was definitely one of the contributing factors to why the stock market kept on dipping. I never recommend borrowing money to invest and especially with money you don’t have. If you borrow $10,000 and the stock you invested in becomes worthless and your broker decides to call in and you have no money to pay back, with a 10% interest rate for a 48-month loan you’re gonna end up paying twice that original amount in interest.

And as far as whether you should invest right now, I can’t give you any specific investment advice. But I can tell you that I’ve been dollar cost averaging my investment by buying stocks and index funds every week. The stocks I’m buying are the ones that I believe in long-term growth.

For people in debt

Next, let’s talk about your personal debt and what happens when the Fed raises interest rates. Raising interest rates means raising the cost of borrowing student loans, personal loans, mortgage loans, car loans, or any other fixed loans. If you’re applying for a loan with a fixed interest rate then you’re most likely going to borrow at a higher rate like mortgage rates right now at 6%.

But if you already secured a loan then your interest and principal payments will remain the same no matter what the Federal Reserve does. What can change is if you have a variable-rate loan. So what that means is that your lender can change your interest rate at any time.

If the Fed raises interest rates next week then your variable rate loans most likely will be the first ones to increase. What’s worse is the interest rates for credit cards and now is the time to pay off your credit card debt as soon as possible. With each rate increase, credit card APRs or annual percentage rates are gonna go up.

For example, if you owe $5,000 on a credit card and currently pay a 20% APR making minimum payments of $100, it’s gonna cost you $5,500 in total interest and takes you 8.8 years to completely pay off the credit card. If APR goes up to 21%, then it’s gonna cost you $6,500 in interest and 9.6 years to completely pay it off.

For home buyers

Next, let’s talk about the most popular topic in the year 2022 and that’s buying a house. With the Federal Reserve raising interest rates, your mortgage rates will most likely go up. Right now at the time of writing this article, a 30-year fixed mortgage rate is at 6.3% and it’s most likely going to 7 or even 8% if the Fed becomes even more hawkish.

What this means is that you’re essentially losing your purchasing power. Home buyers in 2022 will have to pay a lot more for a home loan compared to 2021. Not to mention the housing market in some cities is still selling at an all-time high due to the low level of inventory. And historically speaking the housing market is also a big contributor to high inflation if the demand is still high.

A lot of people believe there will be a housing market crash but I personally think there’s gonna be more of a correction than a crash. I could be wrong but I believe the demand will slow as interest rates continue to go up to 7 or 8%.

Let’s say you’ve been looking at buying a house for $400,000 and the interest rate last year was 3% for the 30-year fixed mortgage rate. Your P&I payments for 30 years would be about $1,800 a month. With a 6% rate today, your P&I payments are now almost $2,500 and that’s actually $700 a month not counting your insurance and taxes.

So in order for your payments to remain at $1,800 a month with a 6% rate, now you can only afford to buy a house for $280,000. And good luck finding a house for $280,000 in the Las Vegas area. What I would expect to see in the second half of 2022 or the first half of 2023 is a decrease in demand for home buyers. Redfin is already reporting that fewer buyers are facing competing offers during the month of May.

Home buyers are facing rising mortgage rates and affordability issues. As a financial coach, I always recommend keeping your housing expenses below 25% of your take-home income. Some people I know are paying almost 50% of their income just for their mortgage payments, which decreases their savings rate and the ability to invest for retirement. Personally, I am not buying any properties for the year 2022.

Final Thoughts

The Federal Reserve is already being pressured to raise interest rates in its attempt to control inflation. Get out of margin debt and credit card debt as soon as possible. A recession usually comes with a higher unemployment rate so have at least 3-6 months of expenses put away in your emergency fund. Be patient with home buying and don’t rush to buy something you’re going to regret.

Disclaimer: Please keep in mind that I am not a financial advisor. I’m only giving my personal experience and thoughts. All strategies, ideas, suggestions, and recommendations offered are exclusively for the purpose of entertainment and education. Investing comes with certain financial risks. You must undertake your own research and due diligence, and if required, seek the assistance of a professional adviser.

Also Read:

9 Golden rules of money and how to put them into action

Why is China’s stock market rising as the US market falls?

Stock Market for Beginners: Ultimate Investing Guide

5 Simple Ways to Manage Your Money Like a Millionaire

Dollar-Cost Averaging vs. Lump Sum Investing Which Might be the Better Option for You

5 Personal Finance KPIs You Must Monitor

How To Save Money – 5 Personal Finance Tricks

Top 7 Tips to Protect Your Portfolio Against a Recession

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