Moving with the Curve

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"Just how long will interest rates be low?” The past year’s record-low interest rates had lenders and borrowers alike asking that very question.

 

Historically low interest rates were due partly to unprecedented steps by the Federal Reserve to stimulate economic growth.

 

“It’s probably safe to say that one of the single most powerful influences on the markets, not just here in the United States but worldwide, has been actions taken by the world central banks to kick-start economies in recession or teetering on recession by, one, creating massive amounts of liquidity, and by two, encouraging investors to take more risks by pushing interest rates down to levels never before seen, at least in recent history,” says John De Clue, Chief Investment Officer for The Private Client Reserve.

 

While the Fed might decide to reduce or discontinue its quantitative easing policies if the economy shows signs of faster growth, we believe it’s unlikely to want to potentially impede stronger economic growth by withdrawing monetary stimulus too quickly.

A low interest rate environment might create potential borrowing opportunities, but “how to react to interest rates is very much client- and transaction-specific,” says David Mook, Chief Private Banking Officer for The Private Client Reserve. “It depends largely on how you’re using your money and what you aim to achieve.”

 

Consider four ways to potentially take advantage when rates are low.

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1. Refinancing

During recent record-low interest rates, many people availed themselves of inexpensive borrowing by refinancing mortgages and other loans. But don’t be discouraged if you didn’t take advantage when rates hit rock bottom.

 

“It may be a good time to refinance when the dollar amount is large, the time horizon is long and the rate can be reduced by at least a full percentage point,” says Aimee Brantseg, Wealth Management Advisor at The Private Client Reserve.

 

2. Borrowing for Projects

Low-cost borrowing also can be used to fund projects such as home or business expansions, especially if it’s more cost-effective than raising the money by selling off assets.

 

“Liquidating an investment to finance a project will cost you the investment return you would have received,” Brantseg says. “If your potential return is greater than the cost of doing a loan, you mightprefer to borrow against the investments and finance the project.”

Conversely, Brantseg says, if you have cash on hand that isn’t earning much of a return, you might choose to use that instead.

 

3. Carry Trades

Another option might be to invest borrowed funds in stocks and bonds you expect to provide a return higher than the cost of borrowing. Such carry trades — common in the foreign exchange market — bring a degree of risk if the portfolio doesn’t yield enough to pay off the loan, Mook warns.

 

Rising Rates: What to Consider

 

Of course, you can have greater risk and volatility related to economic and business developments with stocks, and a return is not guaranteed.

 

Bonds bring their own set of unique risks: Fixed-income investments typically decrease in value when interest rates rise, and this risk is greater in longer-term bonds. International investments bring foreign taxation and currency risks, and the potential for greater volatility.

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You might use the borrowed funds to invest in undervalued long-term assets such as real estate. “People see dislocated assets, such as property, that they feel are now undervalued, and they see these as opportunities,” Mook says.

 

But keep in mind that real estate investments can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties.

 

4. Intrafamily Loans

 

In low interest rate environments, intrafamily loans, or extending loans to family members, also might be more attractive. With intrafamily loans, the IRS requires a minimum interest rate, called the Applicable Federal Rate (AFR), to be charged. 

The AFR, set monthly by the IRS, is generally lower than the prevailing interest rate for commercial transactions.

 

Trust and Estate Opportunities in Low Rate Environments

 

Though rates won’t stay low forever, it’s important not to think about these decisions as interest rate “bets.” “You’ve got reasons for borrowing, and the rate is just the cost of that borrowing,” Mook says. Far more crucial is to work with your advisor to make decisions based on your unique goals and objectives — no matter the current rate environment.   

 

For more on interest rates, read "Interest Rates: How we got here and where we're going."

 

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