There is no shortage of speculation on what will happen with interest rates. Some commentators predict sharp increases and others predict stable rates. Maybe there are some who predict that interest rates will drop a little. Many borrowers listen to these predictions trying to decide whether they have to do anything about their growing debts. This way of thinking is dangerous.

Just because a convincing forecaster says that interest rates will not rise, we should not ignore dangerous debt levels. Debtors should look at the range of possibilities rather than listen to experts make precise predictions. The truth is that nobody knows for sure what will happen with interest rates.

The best rate I was able to find for a 1-year closed mortgage is 2.64%. In three years, this rate could easily be anywhere in the range 2% to 8% or higher. Borrowers should ask themselves what will happen to them if rates rise steadily to 8% in the next 3 years. Will finances be a little tight or will they go bankrupt?

It is the range of possibilities that matters, not the most convincing prediction.

One of the things investors can do is understand the price volatility of the fixed income instruments they buy. For example, if they buy a 10 year Treasury note what will happen to the price of the Treasury note if interest rates move up 2% (or, 200 basis points)? Today the yield on 10 Treasury notes is 2.95% - what if it goes to 4.95% 12 months from now. Many observers see this as possible given the increase in Treasury supply that will be forthcoming because of the rescue program.

ReplyDeleteI can explain how to calculate the impact on bond prices resulting from a rise in yields at

http://rwinvesting.blogspot.com/2010/07/stressed-out.html

Although it takes a little math it is worth knowing.

... or you could pay your debt down as much as possible now, and be less affected (effected?) by interest rate increases later?

ReplyDeleteI'm with BCM. Just pay it down as quickly as you can. Hope for the best, but be prepared for the worst. I guess that fits with Michael's idea of looking at the range of possibilities.

ReplyDelete@DIY Investor: I was looking at this from the point of view of debtors approaching a mortgage renewal or any other update in the interest rates they pay. This kind of thinking applies to bond investors as well.

ReplyDelete@Big Cajun Man and @Balance Junkie: I agree that paying down debt is the way to go. The problem here is procrastination. It's much easier to put off debt reduction until tomorrow if talking heads say that rates won't rise. The key here is to ignore the talking heads that say rates will rise. Then the debtor can procrastinate indefinitely.

If interest rates go up, the only impact on me is that I'll earn a little more on some of my investments. :-)

ReplyDelete(BTW, I owe you a belated thank-you for linking my latest buy-versus-rent rant back in April.)

Aren't fixed rates low now too? Why risk it when you can know for certain what your rate will be?

ReplyDelete@Jenna: Locking in at today's low mortgage rates is a strategy that some people use. However, the interest rate will change again when the term is up. You still have to ask yourself what will happen if the interest rate is much higher at the next renewal.

ReplyDelete