Navigate the financial landscape with confidence in times of high interest rates! Discover proactive strategies to handle increased loan repayments and safeguard your household budget. Learn how to manage finances when interest rates are high, easily and effectively. Ready to take control? Keep reading for practical insights and actionable tips!
Interest rates are known as federal fund rates in the United States and cash rate in Australia. Recently, interest rates began to increase at a rapid rate around the world in 2022 for various reasons. An immediate effect of rising interest rates is higher loan repayments for personal loans and mortgages. This has a direct impact on household budgets. It is, therefore, important to know how to manage finances when interest rates are high.
If you are struggling to keep up with paying loans and bills because of high interest rates, keep reading. Some of the tips below may just be what you need to keep your finances above water!
I will assume you have created a budget, or at least are able to list your income and expenses accurately. If not, the strategies listed below may be more difficult to implement.
For up-to-date information on interest rates in various countries, tradingeconomics.com contains a list of interest rates ranked from low to high.[1]
1. Reassess your budget
When interest rates are high, it can have an impact on loan repayments. Loans commonly impacted include personal loans and mortgages, with higher monthly repayments. To manage the impact of rising interest rates on your budget, it’s important to reassess your budget and make adjustments. Here are a few steps to help you reassess your budget:
- Review your income and expenses. Take a closer look at your income and expenses to see where you can cut back. Identify areas where you can reduce spending and redirect that money towards paying off debt or saving.
- Create a debt repayment plan. Prioritize paying off high-interest debt, such as credit card and personal loan debt, to minimize the impact of rising interest rates on your budget.
- Look for ways to increase your income. Consider taking on a part-time job, working extra hours at your current job if you get paid hourly, or finding ways to earn extra money from home to help offset the impact of rising interest rates on your budget.
- Consider refinancing. If you have a mortgage or other large loans, consider refinancing at a lower interest rate to reduce your monthly repayments.
- Make adjustments as needed. Once you’ve made the initial adjustments, monitor your budget regularly and make changes as needed to stay on track.
2. Review your needs and wants expenses
Assessing needs and wants expenses is an important step in creating a budget and managing your finances. Needs are essential expenses that are required for survival, such as food, shelter, transport and medical care. Wants, on the other hand, are non-essential expenses that are desired but not necessary. Examples of wants include dining out, entertainment, and luxury items.
To assess your needs and wants expenses, you should first make a list of all of your expenses. This should include everything from rent or mortgage payments, groceries, bills and entertainment expenses. Once you have a comprehensive list, you can then categorize each expense as a need or a want.
It’s important to be honest with yourself when assessing your expenses. This will give you a clear picture of where your money is going and where you can make adjustments. For example, you may find that you are spending a lot of money on dining out or entertainment. These are classified as wants expenses. Being aware of these expenses, you can make a conscious effort to reduce them. The added benefit of reducing discretionary spending is freeing up money for more important needs expenses.
It’s important to understand that needs and wants are not always black and white. There are expenses that may fall into a gray area, such as a cell phone bill. While a cell phone is not strictly necessary for survival, it is often necessary for communication and job-related activities. So, it’s important to evaluate each expense individually and decide if it is truly a need or a want.
3. Are you managing your debts appropriately?
Checking if debts are being managed properly is an important step in ensuring financial stability and avoiding future financial difficulties. The first step in assessing debt management is to review all of your outstanding debts. This includes reviewing credit card balances, loans, and any other forms of borrowing. You will then have a clear picture of how much total debt you have and where it is coming from.
Once you have a comprehensive list of debts, review your payment history and determine if you are making the necessary payments on time. Late payments can result in additional fees and penalties, and can also harm your credit score. If you find that you are having difficulty making payments, it may be a sign that further adjustments are needed.
Another important aspect of managing debt is to review the interest rates and terms of your loans and credit cards. If you have high-interest rate debt, it can be beneficial to consider consolidating or refinancing. These can be effective methods for lowering your interest rate and overall debt amount. Additionally, you should check if you are eligible for any financial assistance or debt relief programs.
It’s also important to be aware of your debt-to-income ratio. This is the amount of debt you have in relation to your income. A high debt-to-income ratio can indicate that you may be overextended. If you discover that you are overextended, make adjustments to your spending or debt repayment plan. Regularly monitor and assess your debt management. Monitoring will identify potential problems early and allow you to take steps to address them before they become more serious.
4. Refinancing strategies
- Consolidating multiple loans into one. Consolidating multiple loans into one can help simplify your debt repayment and potentially lower your overall interest rate. This can be done by taking out a new loan to pay off multiple smaller loans, resulting in one monthly payment instead of multiple. This can also help lower your interest rate if the new loan has a lower rate than the individual loans you are consolidating.
- Refinancing to a lower interest rate. If interest rates have dropped since you took out your original loan, you may be able to refinance to a lower rate. Refinancing can reduce your monthly payments and save you money in the long run. Additionally, you can consider refinancing to a longer loan term to lower the monthly payments.
- Home equity loan. If you own a home, you may consider taking out a home equity loan to refinance your current debt. A home equity loan allows you to borrow against the equity in your home, which can often have a lower interest rate than other types of loans. This can be a good option for consolidating high-interest credit card debt or making home improvements. However, it’s important to keep in mind that using your home as collateral for another loan poses a risk of foreclosure if you are not able to make the payments.
It’s important to keep in mind that refinancing is not always the best option for everyone. You should consider your personal financial situation, credit history, and potential savings when deciding if refinancing is the right choice for you. As always, consult with a qualified and licensed financial advisor or loan officer before making refinancing decisions.
5. What about investments?
The theory
In theory, growth stocks are expected to do poorly during high-interest periods. Companies tend to require more capital to fund their growth, which becomes more expensive as interest rates increase. In addition, their valuation is based on their expected profits several years into the future rather than profits today. The tech sector commonly falls into this category.
Bond-like investments such as REITs and utilities that focus on dividend yield may also suffer from investors moving to more secure fixed-income investments.
Stocks that are expected to benefit from rising interest rates include the finance sectors such as banks and insurance companies. Despite experiencing some negative impacts from rising interest rates, with banks borrowing costs increasing and insurance companies holding bonds that fall in value, they usually offset these costs by higher earned interest.
Value stocks are expected to perform better in rising interest rate environments due to their already reduced valuation and higher earned profits.
The practice
In reality, equities have performed well during rising interest rates. From 1954 to 2018, a total of 12 interest rate cycles occurred in the US. Out of those 12 rate hike cycles, 11 of the cycles had positive returns in the S&P 500 index ranging from 4% to 24%. One of those cycles yielded a negative return of -9%. The average annualized return was 9.4% during these 12 rate hike cycles as shown in the following chart [2].
6. Savings accounts and term deposits
One upside to rising interest rates is an increase in interest rates on savings accounts and deposits. Banks will usually increase the interest they pay on these accounts as the cash rate increases. Now is the time to consider whether to move some of your cash from transaction accounts into a high interest online savings account and/or a deposit account.
Transaction accounts generally have very low interest rates, typically much less than 1%, resulting in a minimal increase in your balance at the end of each month. High interest online savings accounts are key to earning more interest from the money you have in the bank. The advantage of these savings accounts is the money can be accessed quickly if it is needed. More information on managing bank accounts can be found in our 6 steps to saving more money fast article.
Banks also increase the interest rates on term deposits, or cash deposits, as the cash rate increases. Check the interest rates on deposit accounts available at your bank to determine if this is a suitable option for you. Deposit accounts are term-based, meaning the cash in the account cannot be accessed during the term chosen without an interest penalty. Typical term lengths can be as low as 1 month, and up to 5 years or more. Each term option will come with an interest rate applicable to the term. Most banks also offer options for interest payments. For example, interest can be paid on maturity, up front, fortnightly, monthly, quarterly, half yearly, or yearly.
Final thoughts on how to manage finances when interest rates are high
If you have high-interest debt, such as debt on credit cards and personal loans, it is worth focusing on paying it down with your cash reserves instead of buying assets such as investments. This would be equivalent to earning the amount saved compared with not paying down the debt and paying higher interest on it.
For example, let’s say you have a personal loan of $10,000 with an interest rate of 8%. You also own stocks to the value of $50,000, which currently yield 4% per year on average. If you have $2,000 available to either pay down the loan or add to your stock portfolio:
- Reducing your personal loan from $10,000 to $8,000 (a $2,000 reduction) will reduce your interest payments for the year by about $2,000 x 8% = $160.
- Increasing your portfolio value from $50,000 to $52,000 (a $2,000 increase) will increase the value of your portfolio for the year by about $2,000 x 4% = $80.
This example shows that you can reduce your losses by $160 by paying down the loan or increase your gains by $80 by adding to the stock portfolio. This difference may seem like a relatively small amount. However, it can make a significant difference when the loan amount and interest rate differ more than the portfolio value and average yield.
Leave a comment below if you use one of the methods listed in this article. If you have other methods that you use to deal with increasing interest rates, feel free to share!
