Recent events have offered dramatic lessons about what can happen when interest rates rise quickly — something that hasn't happened in a surprisingly long time.
For people who are house-hunting, thinking about refinancing a mortgage, or have retirement savings in bond funds, it may have been a bit shocking.
Consider this: If you borrowed $150,000 to buy a house at the average 30-mortgage rate two weeks ago, your monthly payment would have been $90 higher than if you borrowed that same money two months ago. That's an extra $1,080 every year for 30 years, and for most folks that's real money.
Now, mortgage rates are still very low, but that extra $90 a month hints at what can happen when they rise. That extra $90 came from the average 30-year loan rate rising by just over 1 percent, between early May and the end of June.
Will rates rise some more? Almost certainly. But whether that will happen sooner, or later, and whether they will retreat in the short term (as they did last week) is the subject of much debate.
The big picture is that mortgage rates had been driven to all-time lows, below 3.5 percent for a 30-year home loan, by economic conditions and the Federal Reserve's efforts since 2008 to hold rates as low as possible.
While mortgage rates hit two-year highs in recent weeks, the rates available today are still lower than any available prior to 2010. The average rate stood at 4.29 percent on July 3, according to the latest Freddie Mac survey.
Did you refinance a mortgage or car loan recently? If so, you're probably pretty glad you did.
If you were thinking about refinancing but didn't, make your decision about whether to proceed by looking at the best rates you can get now, and any costs of refinancing, and see how that compares to what you're currently paying.
Rates rise and fall. If you are able to refinance and save money, don't worry that you missed out on even better rates, because even the investment pros can't time these things.
Speaking of interest rates, you might think that the recent pop in rates means that banks are suddenly paying more interest on savings accounts, right? Um, not so much.
But I'll bet some long-term savers were surprised by what happened to their “safe” bond funds when interest rates went up.
The conventional investment wisdom is that bond funds are about the safest investment, stocks are riskier, and that you should keep more money in bond funds the older you get and the closer you are to retirement. One rule of thumb I have seen is to keep a percentage of retirement investments equal to your age in bonds (eg: 55 percent if you're 55).
Likewise, most funds that automatically adjust your investment mix as you age, or as your child approaches college-age in the case of 529 plans, move money out of stocks and into bond funds.
But here's the thing many people don't realize. Bonds, and bond funds, are very different creatures.
If you buy bonds, you're essentially loaning money to the issuer, such as the government, or a utility company. So long as they don't go out of business, you generally keep the bond for a certain period of time and get your money back plus specified interest.
Bond funds, however, are highly sensitive to interest rate changes. If rates go up, bond funds generally go down. That's because the bonds held by the fund are suddenly less attractive than new bonds that will pay more interest.
And that's why bond mutual funds lost value when interest rates popped between the second week of May and the last week of June.
For example, shares of the world's largest bond fund, PIMCO Total Return, lost more than 5 percent of their value during that period (disclosure: some of my 401k retirement fund is invested in that fund).
That doesn't mean investors should flee bond funds. They just need to understand the risks.
Reach David Slade at 937-5552 or Twitter @DSladeNews.
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