From mortgages to savings, interest rate hikes have varying impacts
This is the fourth in a series of articles written in conjunction with Financial Literacy Month.
Today we look at current finance-focused impact concerns about minimising inflation strategies being exercised by our three largest neighbours: the Federal Reserve in the United States, the Bank of England in the United Kingdom and the European Central Bank in the European Union.
All finance authorities, in varying degrees depending upon the state of their economies, have responded with increasing interest rates, quantitative easing and related economic management tools.
Why is inflation containment necessary now?
Simple answer: there is more demand for goods and services than supply. A few, but not all, of the causes are:
• An increase in (so called “easy”) money supply
• After years of relatively cheap and available energy, a decrease in production of goods and services, for example due to ripple effects from the destructive forces in the Ukraine invasion
• Pandemic global supply chain crises (toilet paper hoarding is famous)
• Pandemic relief programs
• More borrowing and debt spending
• Rising wages putting pressure on prices
• Factors all contributing to the highest inflation rates in decades.
The end result is households, industries and economies seeing higher prices.
Impact of inflation on finances and investments
Cash: purchasing power goes down. Goods, services cost more across the board, while the value of the same dollar used is whittled away. CPI (Consumer Price Indexes) follow pricing trends closely, for example the US CPI shows that $100 for household consumption in 2017 now costs $118.39.
Savings: savings already in accounts may have riders that raise interest rates in line with central bank hikes.
New savings, term deposits, etc will pay higher amounts, assuming local banks follow global banking patterns. This may be a time, if savings rates increase, to create term deposit ladders. I will write more about this in a future article.
Debt: loans, mortgages, credit cards and Government of Bermuda notes. When the US Federal Reserve increases the discount rate charged to banks, these institutions, in turn, pass the increase on to consumers.
New mortgages, credit lines, and possibly credit cards and so on will be offered at higher lending rates. Internationally, other country banking institutions tend to be in tandem.
For homeowners and other mortgage holders, the impact will depend on the terms of your loan.
Existing – in place – fixed interest rate mortgages and loans issued for the full term to maturity – will not see interest rate changes.
However, existing – in place – adjustable interest rate mortgages and any other loan with those interest conditions are very different. Your interest rate is not fixed!
Anyone who borrowed on this platform should check their contract very carefully, because as interest rates rise across our banking economic spectrum, so will the cost of your mortgage.
There are two ways to manage this:
1, your bank will charge you the same amount each month, but the allocation to principal will be less and conversely, the interest allocation will be more.
2, the alternative is that your monthly payment will increase, due to the increase in interest rate.
Generally, if your bank/financial institution offers it, you may be able to convert your mortgage to a fixed rate for its remaining life.
However, there will most probably be additional fees involved for the conversion; the interest rate may still be higher overall; and, not being able to predict the future, interest rates may fall more rapidly than predicted, in which case the cost to convert may not make financial sense.
Loans and credit card contracts should also be reviewed carefully. The lender may have the right to increase interest rates without notice, such as a floating rate note, or possibly have the right to call the note in order to issue a new loan at a higher rate.
Government bonds: a reader asked what will happen if at the end of the term of any government borrowing, whether upon renewal, the Government will have to pay higher interest rates?
A very pertinent question, thank you, John Joseph.
Under the Bermuda Stock Exchange fixed-income securities listings for the Government of Bermuda, there are a number of senior notes due for principal repayment in 2023. We’ll look at the earliest maturity, which are the 4.138 per cent senior notes, due January 3, 2023, in the amount of $475 million issued on July 3, 2012 (click this link to see the tender offering on August 10, 2020, https://tinyurl.com/bddsj7n9)
Disclaimer: please keep in mind the following are just thought conjectures. I have no access to actual insider information and the full contract, so another caveat, none of these possibilities may apply.
There could be numerous outcomes and varying interest rates depending upon how the tender offering is structured. This note appears to be priced at a premium above par, so at maturity, the principal repayment may be slightly less than the investor purchase price.
• First, how the interest rate environment is in early 2023 must be considered
• Generally, if global interest rates have risen / are still rising, a higher interest rate is needed for a new offering to induce investor participation
• Possibly a rollover of the existing note, again with a more contemporary interest rate in the offering
• A pay-off of the matured note, and completely new tender offer, with an interest rate reflecting credit rating and interest rates at the time
• Details in a new contract offering might allow the investor a put provision if the interest rate is not as competitive. Research “bond put provision”.
Money market mutual funds: these are generally high-quality, short-term debt, commercial paper and cash equivalents, all less than nine months in maturity. Highly liquid, their underlying securities revolve around prevailing interest rate changes. Interest rates are low now, but will increase in tandem with prevailing rates – remember money market mutual funds paying 6 per cent or so in 2007, before the subprime capital market crash.
To be continued.
Part five: final article on inflation impact on stocks and other investments, on April 30.
House of Commons Library: Interest Rates and Monetary Policy: Key Economic Indicators, April 14, 2022, https://commonslibrary.parliament.uk/research-briefings/sn02802/
US Consumer Price Index April 12, 2022, https://www.bls.gov/news.release/cpi.nr0.htm
• Martha Harris Myron JSM is a native Bermudian with US connections. She is an Amazon / Apple published author of the Dawn of New Beginnings, Book One of The Bermuda Islander Financial Planning Primers. Contact: email@example.com