Making the Most Out of Low Interest Rates

By Lee Bellinger / September 28, 2015
By Seth Van Brocklin
  • The Federal Reserve has adopted a chicken-out policy on interest rates.
  • Inside: Hunting for yield in a low-yield environment.
  • In the market for a home loan? Learn how to get a mortgage rate below 3%!

Zero Interest Rate Policy isn’t going away just yet. In September, the Federal Reserve passed on the opportunity to raise rates – even by just a measly quarter point. Let’s consider what that means for your investments and personal finances…

First of all, Fed officials clearly feared setting off a stock market crash. The market gyrations of late summer that began in China and started spreading to the U.S. caused the Fed to chicken out on hiking rates. The stock market may be headed for a crash anyway, but Fed officials wanted to at least make sure they wouldn’t get the blame.

Fed chair Janet Yellen had spent months rhetorically prepping markets for rate hikes. Many investors were expecting the Fed to actually follow through. Now the central bank has a credibility problem.

Fed policymakers are still talking about steady hikes in the Federal Funds rate to achieve a more “normal” looking yield curve by next year. So far, they’re all talk and no action.

Real Interest Rates Could Rise Even if the Fed Keeps Holding Down Nominal Rates

At some point, the market will force interest rates higher in real terms, regardless of whether the Fed is a willing participant. In the meantime, the current artificially low interest rate environment presents both risks and opportunities. Perhaps the greatest risk for the average person is not understanding the difference between nominal and real interest rates.

The mainstream financial media does the public a disservice by obsessing over the nominal rate set by the Federal Reserve. The way some analysts parse every statement the Fed makes and try to decipher hidden meanings behind every syllable contained in a policy statement strikes me as cultish.

Time spent looking for clues as to what’s on the minds of the high priests of monetary planning is time that could have been spent researching real financial strategies or investment opportunities. What matters when it comes to interest rates is their relationship to the inflation rate. When nominal rates are below inflation, that means real rates are negative.

Negative real interest rates mean you can expect to lose money by putting it in a bank account or Treasury bonds. You have to find higher-yielding assets such as dividend-paying stocks or real estate investment trusts in order to have a chance at generating a positive real (after-inflation) return.

When real rates are negative and stock markets are overvalued, then precious metals become relatively more attractive to hold. Gold and silver are not guaranteed to hold their value over any given near-term time frame. Since 2011, they have both lost value. Over time, however, precious metals have proven to hold their value better than cash and bonds during periods of negative real rates.

This Blue-Chip Stock Now Yields 6.1%

There are also opportunities in high-yielding resource stocks. Even though the U.S. stock market is historically expensive, with most sectors sporting unimpressive dividend yields, there are exceptions.

Take a stock like ConocoPhillips (COP). Its share price has been pummeled over the past year as crude oil prices declined and investors turned negative on the energy sector. That has created opportunity in the form of a dividend yield that has surged to 6.1%.

There’s a chance ConocoPhillips could be forced to cut its dividend. That’s why dividend investors need to diversify among companies. They should diversify among sectors and countries as well to ensure they aren’t overexposed to an area of the market that runs into trouble.

For those who want to focus on quality global energy stocks that now sport some very impressive yields, iShares Global Energy (IXC) is a good way to play it. IXC holds shares of ConocoPhillips (2.9% of portfolio weight) and 80 other big names in the global oil and gas space. The exchange-traded fund has $808 million in assets, carries a 0.47% expense ratio, and delivers an estimated yield of 3.4%.

It is possible to put together a high-quality dividend stock portfolio that yields more than what you pay to borrow money. I don’t advise investing on margin, but now is certainly a great time to obtain low-cost financing through a mortgage.

Rock-Bottom Mortgage Rates

Mortgage rates tend to closely track the yields on the 10-year Treasury and 30-year Treasury bond. The Fed doesn’t directly control bond yields, though it can certainly intervene in the bond market to exert pressure on rates. But if foreign buyers start ditching Treasuries, and if inflation expectations start rising, then long-term interest rates (and therefore mortgage rates) can rise. They can rise even if the Federal Reserve holds its benchmark short-term rate near zero.

I recently purchased a new home out in the Montana woods. Not so far out that I’m cut off from civilization, but far enough out that I can enjoy a great deal of privacy. I can enjoy a sense of being physically removed from crime, pollution, government snoops, and other unpleasantries. And costs of living here are quite low compared to hip and trendy cities where even a $100,000 a year salary may not be enough to be able to afford a small condo.

Regardless of whether you prefer a rural or an urban or a suburban lifestyle, you’ll want to be able to put as much of your housing costs as possible toward your house rather than your inancing. Banks will hit you with a bevy of fees, the big one being the “origination fee.” However, you may be able to negotiate discounts on origination and processing fees.

Or, by shopping around, you may be able to find a lender who charges less in fees. Unfortunately for buyers, the days of no-documentation, nothing-down loans are mostly over. (You may be able to find a niche lender who will of fer low-doc loans for small business owners or others with unconventional financial situations. But those types of loans will typically carry higher interest rates.)

Banks now want to document virtually every aspect of your finances. It’s a personally invasive and in some cases exhausting process to get a mortgage underwritten and off to closing. If you can pay cash for a property, you can avoid most of these hassles.

On the other hand, today’s low rates make it tempting to take out a loan even if you don’t need one. You can now get a rate of under 4% on a 30-year fixed mortgage. And if you have good credit, you may be able to lock in a rate of just under 3%. Yes, under 3%.

How? By opting for a 15-year fixed or an adjustable rate mortgage (ARM).

The downside to a 15-year fixed is that it saddles you with higher monthly payments. The upside is that you gain equity and pay off your loan much quicker and pay far less in interest costs to your lender.

Footing the Risk for an ARM’s Length Loan

If you want lower monthly payments and lower interest costs than a 30-year fixed, then consider an ARM. With a 5/1 ARM, the rate you are quoted is fixed for 5 years. After that, the rate will move up or down according to the prevailing benchmark rate.

When I was shopping for a mortgage and asked a loan originator to quote me some numbers, the document he prepared included only a breakdown of costs on a 30-year fixed. When I asked him about an ARM, he seemed surprised. He said the bank rarely did adjustable rate loans, but that, yes, they are available. And yes, after he ran the numbers, I saw the significant savings I’d enjoy in terms of lower monthly payments. I opted for the ARM.

Adjustable rate mortgages have gotten a bad rap as being riskier than fixed-rate mortgages. Yet over time, they’ve worked out comparatively better for most people. Of course, that’s largely because interest rates have stayed low. When rates start trending higher, ARMs could come back to bite those who took them out.

So what was I – a person who fully expects higher interest rates and rising inflation in the coming years – thinking in getting an ARM? Part of my reasoning was personal; part more philosophical.

A major tenet of my philosophy of investing and personal finance is to minimize expenses at every opportunity. I’ve pounded the table in this newsletter about the importance of reducing transaction costs, management fees, taxes, and other drags on investment returns. Buying a home should be approached in the same way – with an eye toward minimizing transaction and interest costs.

An ARM is the lowest cost way to get into a home. And the risks aren’t as severe as you might think. An adjustable rate mortgage will typically subject borrowers to a maximum readjustment of 5 percentage points – meaning if your 5-year lock is at 3%, the most it can rise after that is to 8%.

That kind of worst-case scenario increase would jack up monthly payments, but it probably wouldn’t be financially ruinous. Moreover, it would be possible to refinance the loan before rate readjustments set in.

Whatever Your Financial Strategy May Be, Be Prepared for the Unexpected

A big factor in deciding whether to opt for an adjustable or a fixed rate loan is how long you anticipate living in the house you’re financing. Most people say they intend to live in their home for around 20 years, but in fact the average person moves about every 7 years.

In my case, I figured there would be about a 50% chance that I would want to sell the house (or have to move for some unexpected reason) within the next 5 years.

In the meantime, I’ll be depriving bankers of less in interest than they would have gotten had my loan originator succeeded in steering me into a fixed rate loan. That gives me great satisfaction!

Be Certain to Invest Your Short-Term Savings

And to help ensure that my decision proves to be financially sound, I’ll allocate my savings from a lower mortgage payment each month to investments. Over the next 5 years, I’ll be able to acquire a few more ounces of silver and a few more shares of dividendpaying equities thanks to my lower-rate ARM.

Whether it’s through an ARM, a fixed rate loan (if you’re more comfortable with that), or a refinancing of an existing loan, the current mortgage market presents rare opportunities. Today’s low rates probably won’t persist much longer. No one knows the future, though. So as always when it comes to your personal finances, be Ready for Anything.

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