The question of whether Federal Reserve Chairman Alan Greenspan will raise interest rates sets the stock market on edge several times a year. In February 2000, the Fed raised its rate by one-quarter of a percentage point, which was the fourth rate increase since June 1999.
If you think only bond traders or hard-core investors should care, you are wrong. Although your world won't be rocked by small changes in interest rates, your investments -- and the rest of your financial life -- are very much affected by changes in rates, especially when the change is a shift in a new direction. Often, one increase in rates will be followed by another.
Stock Market Jitters
The reason most stock market bulls start running for the hills at the hint of an interest rate increase is that higher rates traditionally have pushed stock market prices down. That's because higher rates mean that companies must spend more to make things, which lowers their earnings. And investors will shift money from stocks to more reliable, interest-bearing investments such as bonds
The Federal Reserve meets eight times a year, and rate changes are generally announced at those meetings. So in the days leading up to a meeting, the stock market can be volatile. If professional investors anticipate that rates will rise, they may sell stocks and buy bonds. But how dramatically the market reacts to rate changes also depends on the size of the change and other economic forces.
Interest rate changes may affect the returns on your investments. If the change is small, a quarter point or so, you don't need to adjust your overall strategy.
But if rates increase dramatically, either with one change or in several changes over a year, it may be a good time to look at adding more bonds to your portfolio. Just keep in mind that younger investors who have a long-term horizon should keep the bulk of their funds in stocks to benefit from growth of the market.
Where You Will Feel It
The interest the Fed charges to lend money to banks affects the interest rates banks offer when they lend money to you. So most of us will feel the impact of rate changes on our personal finances.
Interest rate changes don't change the amount you owe on any existing loans, such as the car loan from last month or the mortgage you took out last year.
But they often affect the interest you will pay on loans you take in the future. If you borrow $10,000 for a car loan from a bank at a five percent interest rate, you will pay the bank $500 a year in interest, on top of your monthly loan payments. If the rate jumps to seven percent, you will pay $700 a year. Just think how much that $200 extra adds up to over the course of several years.
If you're planning on borrowing a large amount of money for, say, a mortgage, every fraction of a point counts, so if you expect rates to go up, you should try to lock in the lowest rate possible. It also should affect your decision between a fixed-rate or an adjustable-rate mortgage. If you think rates will begin to trend upward, you may be less willing to take the risk of an adjustable loan.
Higher rates mean you have to make sure you shop around for the lowest possible rate on credit cards or car loans. And higher rates mean you will pay more, so you run more of a risk of getting in over your head. In an environment of high interest rates, you need to be more careful than ever about staying out of debt.