Cheap Money Isn’t Always Free Money: How To Invest Smart When Rates Drop
Written by
Martin Dasko
Edited by
Zuri Anderson
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According to recent calculations from CBS News, the rate cuts from the Fed brought the interest rate for a $40,000 10-year HELOC down from 8.12% in March to 7.82% in November. This means that payments dropped from $487.85 per month to $481.51, which isn’t a significant reduction, but it’s clear that there’s a trend in response to rate cuts.
As the Fed continues with rate cuts, it’s evident that lower borrowing costs can tempt both businesses and individuals into overleveraging and endangering their finances.
“Lower rates present more of a quandary for individuals than they do for most businesses,” said Robert Varghese, head of investments for Groundfloor. “For a business, lower rates mean a lower cost of capital that will allow more favorable financing for projects or operations. For individuals, lower rates can also mean lower borrowing costs (e.g., lower monthly payments if you have a variable interest rate).”
We will contrast disciplined versus reckless strategies so that people can understand how to manage their money amid the current interest rate environment.
Disinclined Strategies for When Rates Drop
As rate cuts continue, you’ll want to consider a few key disciplined approaches to invest the smart way.
Act Before It’s Too Late
Joey Isaacson, the CEO and co-founder at Nook, pointed out that the key is to act before rates drop further so that you get the best return possible for your money.
“Look for platforms that offer real-time yield optimization, full liquidity, transparent controls and clear fee structures,” he elaborated. “Don’t get caught chasing yesterday’s rates in [certificates of deposit] CDs when you could be accessing tomorrow’s opportunities in diversified money markets.”
Lock-In Higher Yield Investments
Varghese noted that from an investing standpoint, lower rates mean potentially lower fixed-rate returns moving forward. He added, “As such, it would be prudent for investors to lock in yielding returns while they can.”
Right now is the ideal time to lock in your funds at a higher rate to ensure that you’re earning the best rate possible. You want to ensure that you won’t need to access these funds until the term is up.
Invest In Quality Companies
“While there are risks, investing during periods of falling interest rates can also be rewarding,” remarked Tim Thomas, chief investment officer and wealth manager at Badgley Phelps Wealth Managers. “When rates are falling and growth is below average, growth stocks can perform well.”
The belief is that these companies can increase earnings when the economy is experiencing modest growth. The objective is to invest in high-quality companies rather than chasing riskier options simply because borrowing money is cheaper.
Take a Balanced Approach With Your Portfolio
Thomas advocates for a more balanced approach during a period of falling interest rates, acknowledging both the risks and opportunities. He urges that you focus on high-quality assets, diversify and use debt wisely.
Reckless Strategies for Lower Rates
The following are reckless strategies during periods of low rates that can lead to financial issues.
Taking High Risks
Isaacson warned that rather than rushing into risk, it’s essential to look for other opportunities that might generate better yield without exposing yourself to speculative bets. Thomas warned that periods of economic expansion can create the illusion that high levels of debt are sustainable, but that may not be the case in times of financial stress. Even though borrowing costs have been reduced by lower rates, you’re not immune to possible financial issues.
This logic also applies to businesses, as they may be tempted to invest in significant projects that require financing a substantial amount of debt, simply because the cost of borrowing the funds is lower. While the cost to borrow money might be dropping, it still isn’t free money, and you have to be aware of the potential consequences of defaulting on the debt.
Using Leverage and Investing on Margin
Thomas noted that during times of falling rates, it can be tempting to use leverage to enhance returns. However, he stressed that leverage amplifies returns, both positive and negative, so you’ll want to be cautious about using a strategy that relies on debt as a business or individual.
Robert R. Johnson, PhD, chartered financial analyst (CFA), chartered alternative investment analyst (CAIA), professor of finance, Heider College of Business, Creighton University considers investing on margin to be a reckless strategy for businesses and individuals when rates drop.
“Many novice investors believe that since markets usually go up they can increase their returns by borrowing and investing on margin,” he elaborated. “If you try to magnify your returns by using leverage, you may not have the financial wherewithal to withstand the interim volatility before the wisdom of your decisions pan out.”
As time has proven over the last five years, there are very few guaranteed investment opportunities that yield substantial results in this economic climate. It’s also worth bringing up that many individuals and businesses may not have the stomach or capital to maintain positions until the market corrects itself.
Borrowing Too Much
Thomas warned that to avoid debt issues, you must understand the payments required on your debt in relation to your cash flow. If you borrow too much money just because rates are low, you can overleverage yourself.
This logic applies to both businesses and individuals, as debt payments can become a substantial financial burden. While experts anticipate further rate cuts, there are no guarantees as to the amount that rates will drop over the next few years.
Isaacson concluded, “Ultimately, be patient and remember: Your cash doesn’t have to accept whatever rate your bank decides to offer. Make sure your money works more for you than your bank.”
You want to ensure that you’re earning the best possible return on your funds with a level of risk that you can personally tolerate.
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