Inflation, interest rates, central banks, monetary policy. Jargon.
Let’s start from the beginning – with central banks. Their main job is to control inflation so that we have relatively stable prices. And their target for this is set at around 2%.
Now let’s turn our attention to the economy. Think of it as a bowl of porridge. No one wants it too hot (high inflation) or too cold (low inflation). We want a delicious bowl of Goldilocks’-style porridge.
When the porridge gets too hot, or too cold, central banks will need to adjust the temperature through what’s known as Monetary Policy. They have some tools at their disposal: interest rates or quantitative easing (money printing).
Prices (from food to wages) can rise due to supply and demand or a combo of both. Right now, we have both. Unlucky, I know. We are experiencing a nasty mix of rising demand with supply chain issues. People are happily spending but supply just can’t keep up. Think of it like a blocked drain. The water just won’t flow. But eventually, it will all come flooding out.
So, when all this inflation gets out of control, much like is happening now, central banks can choose to raise interest rates (turn down the heat), making the porridge a lot easier to eat without scolding your mouth.
Now that Econ 101 is outa the way, let’s get down to the belly of the matter – interest rates.
Interest rates, simply put, is the cost of borrowing (think mortgages, credit cards, car loans) or the reward for saving. When rates rise, it will be more expensive to service your debts but on the flip side, you’ll get a little more on your cash in those savings accounts.
This tool can take some of the heat out of the economy because consumers will be less likely to splash like there’s no tomorrow which means they could turn to saving their buck hence putting the breaks on inflation.
The Bank of England has dogged raising rates this month but there’s talk they could do so before the end of the year. This is a rather novel prospect for many of us since we’ve had a decade of rock-bottom interest rates. (Though rates aren’t gonna rise to pre-pandemic heights all at once. Think if it like a gentle ascent). Though we’ve not interest rates higher than 0.5% in a while. But some decades ago, life was different.
Living in the 70’s, interest rates were hitting double-digits – at 17%! Who would bother with all that investing stuff when you could simply chuck all your money in the bank and earn a risk-free return of 17%? Sounds like a dream? Well here’s the catch: prices were going up by greater numbers. In the mid-70s, inflation hit 25%. Unemployment was rife and life was just tough.
Now, in the UK we have inflation averaging 3.9% which is higher than we would like hence the looming rate rise. But don’t be alarmed. Here are four things that you can do to leave you with more in your pockets each month – rate rise or not.
4 tips to prepare for rising interest rates
1. Paying off your debt should be your number one priority right now. Start with your highest-interest bearing debt and pay that off, moving on to the second-highest and so on until you’ve got all that nasty staff outa the way.
Before you even think about investing, or even saving, pay off that debt. You don’t want to get locked in with far higher rates.
2. If you’ve got a mortgage on your property, fix it for as long as you can so that you can lock in these ultra-low interest rates which will hopefully allow you to keep your monthly mortgage expense somewhat stable. Food and energy prices are rising fast enough and the last thing you need is for your mortgage bill to go up, too.
3. It’s not just mortgages that will rise in price. It’s car loans, too. So, if you’re on a car repayment plan, and have only put up a small deposit, consider increasing it to pay off a greater chunk of your loan. Or, consider ditching your car altogether. This is a seller’s market so your car (old or otherwise) could fetch a hefty sum.
4. Diversify your investments. High-growth stocks might not be all the rage for much longer so now’s your chance to diversify your portfolio. Don’t think that the US will continue like this forever. Be sure that you’ve got stuff in there to protect you from inflation because trust me, when it bites, money now rather than maybe-monies is what you’ll be after.
Grow it; don’t shrink it.
You want to focus on accumulating as many assets (stocks, real estate) as you can. You do not want to be lumbered with liabilities (cars, handbags, fancy clothes) especially ones where you’ve taken out a loan on!
Take out a loan (mortgage) on an asset (house) by all means since you’re building your asset base and once you’ve paid off that mortgage, you’ll own your house outright and it will hopefully keep appreciating in value. But cars on the other hand, are not the most financially-savvy purchases out there – unless it’s a classic, of course! Read here why you don’t really need a car (and a bunch of other stuff).
Here me out: say you want to get your hands on a fresh 2021 Merc. Fresh outa the showroom. I know, there’s a zero chance since there’s a major backlog but let’s suppose you can!
Its hefty price tag is £50k. Seeing as you don’t have £50k splashing around (I mean, who does?!), you pay a couple grand, say £5k, upfront and the remaining £45k is put on a loan. So now you owe £45k. And with a 7% interest rate, you could be looking at some mammoth monthly repayments.
Then there’s the prospect of this interest rate rising in value. You’ve gotta be able to afford a higher rate on your monthly repayments. Your debt (in this case a car loan) is going to be much harder to service.
You may tell me (and rightfully so) that hey, at the end of it, I’ll own my very own auto! Yes, that’s correct, but cars don’t typically tend to rise in value. As soon as you drive outa the showroom, your car’s value will have already depleted.
Yeah this pandemic has completely spun everything on its head. Second-hand car prices are going up in price because it’s just so hard to get your hands on a fresh model thanks to supply shortages. But, in normal times, new cars shed their value, fast.
So, in this uncertain realm of potential rate rises, record-high asset prices (from Bitcoin to property), the last thing you want is to be caught on the wrong side of it all.
Be cautious in your spending and never spread yourself too thin. Oh, and don’t forget to always have a pile of cash for those rainy days to prevent your finances from going haywire landing you in trouble. Read here how to build your own emergency fund.
As ever, plan for the worst but hope for the best!
Disclaimer: This blog is not investment or financial advice. It is my opinion only. This blog is not a personal recommendation to buy/sell any security, or to adopt any such investment strategy. Always do your own research before you commit to any investment.