Although interest rates affect every one of us, most of us don’t or can’t be bothered to understand what they mean. As any introductory economics student is taught, interest rates are considered the price of money. (If money having a price sounds tautological — a dollar is worth $1, what else is there to talk about? — read on.)
The higher interest rates go, the more valuable currency is in the sense that it’ll cost more to repay over the period of the loan that the interest is being charged on. When interest rates approach zero — and in some cases, go beyond — money is “cheaper” and thus more easily borrowed for a mortgage, car financing, etc. Interest rates throughout the world, and particularly in the U.S., are at historic lows. What does that mean for the long term? Or, for that matter, the short and medium terms? (For more, see: How Does Wage Price Spiral Impact Interest Rates?)
Ideally there would be a standard universal interest rate, as fundamentally and naturally constant as "pi" being the ratio of a circle’s circumference to its diameter. Instead, interest rates fluctuate beyond the ken of individual buyers and sellers.
The Federal Reserve Chairwoman recently announced that the Federal Reserve Bank would be raising the federal funds rate, a power that Congress has ceded to her agency. This won't happen immediately. Instead, she cautioned borrowers and lenders of eventual hikes, something she’s done several times before. (One day, her warnings will inevitably portend the truth.) The federal funds rate serves as a benchmark for everything from 30-year mortgage rates to credit card rates, lenders adding basis points as they see fit. As it stands, the federal funds rate is effectively zero, which is remarkable enough in itself. What’s more remarkable is that rates have barely moved over the past six years, a relative eon.
Economics is not a zero-sum game. If it was, global wealth wouldn’t have increased one whit since the dawn of civilization. However, it’s fair to say that certain price levels might benefit buyers more than they do sellers, or vice versa. With money prices (again, identified as interest rates) at unprecedented lows, it follows that it should be a great time to owe money and a less great time to be owed it, which is more or less the case. (For more, see: Understanding Interest Rates: Nominal, Real and Effective.)
Can't Go Much Lower
Assuming that the six-year trend must end at some point and that rates will again approach traditional norms, among the first people to feel it will be the adjustable-rate mortgagors. ARMs, typically distinguished from fixed-rate mortgages with an introductory teaser rate, have barely moved from that teaser rate since the onset of the ultra-low interest era. In the late 20th century, when federal funds rates of 3% or 4% were the norm, ARMs were derided as the dangerous bets taken by people with shaky financial resources, desperate to finance a house and unable to secure a fixed-rate loan. Those lucky enough to capitalize on low ARM rates at the time are now entering the home stretch on their 30-year loans. Mortgagors who recently took out ARMs, however, could see their monthly payments skyrocket the moment interest rates revert to their natural level.
The same goes for the holders of home equity lines of credit, which many homeowners regard as free money pots and few homeowners see as what they really are: de facto second mortgages. If you dipped into your home’s equity to buy a boat or a snowmobile, that toy could end up being as big an albatross and take as long to pay off as any five-digit credit-card balance. (For more, see: Is Your Mortgage Robbing Your Retirement?)
It stands to reason that if borrowers suffer from incipient rises in interest rates, lenders benefit. A rising interest-rate realm is a great place to be if your income includes debt issues, like mortgage-backed securities, for instance, or exchange-traded funds (ETFs) created out of the same. If we really are in an asset bubble that’s expanding thanks to a low-interest rate environment — the price/earnings ratio of the Standard & Poor’s 500 is currently about one-third over its all-time average — debt will become more attractive for investors relative to equity.
The Bottom Line
Conventional wisdom states that rising interest rates are a harbinger of a stronger economy. (Tell that to the people who experienced stagflation in the 1970s.) The U.S. economy actually contracted over the first quarter of 2015, a stunning if not singular development for a heavily industrialized nation with an increasing population. Lay that out side-by-side with infinitesimally small interest rates, and some investors will look hard enough to see causation. At low interest rates, some parties benefit, and at higher ones, their opposites do. Until we reach Milton Friedman’s utopia — an economy in which the money supply grows with the population, plus a constant — interest rates will never be in true market equilibrium. In the meantime, we’ll continue to have winners and losers, or more fairly, beneficiaries and payers of interest-rate movements. (For more, see: What a Tech Bubble Could Mean for the Economy.)