How Interest Rates Affect Your 401k
Finance is like an ongoing game of dominoes. Small changes can cause significant effects in other parts of the financial sector. These changes then cause even more effects throughout other areas of finance.
We’ve seen this over the last few years as inflation impacted prices. This caused a shift in interest rates as the Fed attempted to combat the effects of inflation. Rising inflation rates then impacted how people and companies could borrow money, affecting prices even more.
But if interest rates can cause ripple effects throughout the financial sector, does that mean it can impact our retirement?
The simple answer is “Yes.”
We remain dedicated to guiding you all through the retirement planning process. And, while interest rates appear to be coming down, they’ll likely rise again before most of us retire. So, we wanted to explain how interest rates can impact our retirement plans and how to successfully navigate rising rates to protect our investments and minimize our losses.
How Do Interest Rates Work?
Before we delve into the nitty-gritty of how interest rates impact your 401(k) account, it’s essential to understand how interest rates work.
Simply put, interest rates measure the cost of borrowing money. The rates are primarily influenced by central banks like the Federal Reserve (“the Fed”) in the United States, which adjust rates to manage economic growth and inflation.
When the economy is robust, central banks raise interest rates. This makes borrowing money more expensive, which helps temper growth and control inflation.
During economic downturns, the Fed may lower rates to make borrowing money easier. This can stimulate spending and growth.
These rate fluctuations can ripple through various financial sectors, affecting everything from credit cards and personal loans to mortgage rates.
Understanding Prime and Fed Funds Rates
Two key rates that serve as a foundation for most interest rates in the U.S. are the Federal Funds Rate (or “Fed Funds Rate”) and the Prime Rate.
The Fed Funds Rate is the interest rate at which banks and credit unions lend reserve balances to other depository institutions overnight. The Federal Open Market Committee sets it. This impacts banks’ ability to borrow and stay liquid, influencing the interest rates they charge other borrowers. This is what people refer to when they talk about the Federal Reserve raising interest rates.
The Prime Rate, on the other hand, is the interest rate that commercial banks charge their most creditworthy customers. This rate is usually around three percentage points above the Fed Funds Rate. Most lending rates, including some types of mortgages and credit card rates, are based on the Prime Rate. When the Fed changes the Fed Funds Rate, the Prime Rate typically follows suit.
Of course, the less creditworthy you are, the higher your rate is likely to be.
Why Interest Rates Matter
So, why do interest rates matter with a 401(k)?
The crux lies in the cost of borrowing.
The Fed raising rates means higher borrowing costs, which can make individuals and businesses less inclined to take out loans. Reduced borrowing leads to decreased spending, potentially slowing economic growth. This, in turn, can impact the stock market’s performance and, subsequently, your 401k plan.
The Connection Between Your 401k and Interest Rates
Your 401k plan is likely a significant component of your retirement planning strategy. That’s because most employers offer a 401k plan, making them an easy option for establishing a retirement plan.
A portion of your pre-tax income gets contributed to your 401(k). That money gets invested into various investment types that create steady, long-term growth. Usually, these investments involve a selection of mutual funds comprised of stocks and bonds.
As mentioned above, interest rates can impact the value of stocks. If they cause stocks to go up, your investments can grow—and with it, the value of your 401(k). Therefore, if the stocks go down, your 401(k) could then lose value.
How to Navigate the Waters of Rising Interest Rates
So, as interest rates go up, the value of your 401(k) could go down.
This raises the question: “How do I navigate rising interest rates to protect my 401(k)?”
Of course, the nuances of navigating any market shift can depend on the specific circumstances surrounding the change and current market trends. However, there are a few strategies you can keep in mind to help you minimize losses during a period of rising interest:
1. Diversify: The oldest strategy for market success never goes out of style. Try to spread your investments across a variety of asset classes. This strategy can help mitigate risks associated with market volatility, ensuring that your portfolio isn’t overly reliant on one type of asset.
2. Rebalance: If your portfolio becomes too heavily weighted towards one type of investment, it may be time to rebalance. This can entail determining which kind of investments are performing best during the rise in rates and weighing them more heavily in your portfolio.
3. Review Bond Holdings: Consider the composition of the bond portion of your 401k. Bonds with longer maturity periods are generally more sensitive to interest rate changes, and your portfolio could be at risk if these bonds constitute a large portion of your investments.
4. Stay Calm: Markets fluctuate, and interest rates rise and fall. It’s crucial to remember that retirement planning is a long-term process. Making rash decisions based on temporary market conditions may do more harm than good. So, remain calm as you consult with professionals and assess the market’s performance.
5. Consult with a Financial Advisor: Navigating through a changing economic landscape can be challenging. A financial advisor can provide professional insights and personalized advice tailored to your specific needs and goals.
The Role of Rising Interest Rates in Retirement
With the context of how interest rates can affect your 401k established, let’s delve deeper into how rising rates can shape your broader retirement landscape. The shifting tides of interest rates play a significant role, particularly in areas like savings accounts and various forms of debt.
Impact of Rising Rates on Savings Accounts
Rising rates can impact more than just your 401(k). For example, interest rates can affect your savings accounts. As interest rates rise, it becomes harder to borrow money. This can reduce the number of customers a bank may have. The bank might raise yields on their savings accounts to attract more customers. This is good news for retirees and retirement savers, as it means your money works harder for you, yielding higher returns.
Retirees typically move a portion of their investment portfolio to safer, interest-bearing accounts like savings accounts and CDs. Higher interest rates mean more income from these accounts, which can help cover living expenses. The key here is to regularly shop for the best rates, as not all banks will offer the same interest rate on savings accounts.
Also, keep in mind the difference between your savings account yields and the inflation rate. Often, inflation rates can outpace even high-yield savings accounts.
Higher Borrowing Costs
High borrowing costs impact more than just the stock market. It can affect your ability to make big purchases (such as a home or a car) or the debt you incur by making those big purchases.
High mortgages, car payments, and credit card APRs can follow you for years—even decades. This is especially true if you get locked into a high fixed interest rate. This can increase your monthly payments, straining your ability to save for retirement. If you make any of these purchases during retirement, the high rates can vastly impact your retirement budget, leaving less money for other expenses.
Rising rates could make these loans more expensive for those considering personal loans, such as a reverse mortgage. However, these impacts can be mitigated by shopping around for lower rates, waiting for rates to come down, or consulting with a financial advisor.
Prime Rates and Credit Cards
Most credit cards have variable interest rates tied to the prime rate, which, as mentioned earlier, is influenced by the Fed Funds Rate. When the prime rate increases, so does the interest rate on your credit cards.
If you carry a balance on your credit cards, rising rates mean your debt will accrue interest faster. This can make it more challenging to pay off your balances, as more of each payment goes toward interest rather than reducing the principal.
To mitigate this, consider these two strategies:
- Pay off high-interest debt first, and
- Transfer the balance of high-interest cards to lower-interest cards
As always, you should consult your financial advisor before making big decisions concerning your debt and financial health.
Adjustable-Rate Mortgages
Much like credit cards, some mortgages can also have variable interest rates. This means the Fed raising interest could cause your mortgage payments to go up, even if only temporarily. This can impact budgets—especially for those living on a fixed income during retirement.
You could consider refinancing to a fixed-rate mortgage to avoid these changing rates. However, the benefits of refinancing can significantly depend on your specific situation. So, please consider consulting with your financial advisor to determine if refinancing can help.