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How will rising interest rates affect you?

Bank of EnglandThe Bank of England’s Monetary Policy Committee (MPC), which sets the UK’s official interest rate, meets eight times a year. Its job isn’t to control interest rates, it’s to control inflation. Inflation goes up when we spend more money, which grows the economy.

The MPC has just announced a rate rise for the first time in a decade, setting rates to 0.5%, and increase of 0.25%.

How will that potentially impact your finances?

Savers

For savers it should be good news of course, with other banks following Threadneedle Street and raising their rates too. After a decade of rock bottom interest payments, this will be welcome relief; but bear in mind that the difference in reality is negligible: If rates rise by the predicted 0.25%, that would mean only an extra £25 each year on a £10,000 cash ISA.

It’s a step in the right direction, but savers won’t be breaking out a ticker tape parade just yet.

Property owners & buyers

When interest rates go up, the cost of buying a house becomes more expensive because the cost of a mortgage goes up. Property is a fixed-income investment, and when interest rates rise, fixed income investments go down in value.

I anticipate a stabilisation of the property market rather than a big fall, demand is so high that I don’t see a big crash, rather a levelling out of price growth (as we’ve already seen with stamp duty increases). And as with savers, the impact of a 0.25% rise is unlikely to be huge unless you have a mortgage in the high six- or seven-figures.

Pension holders

Pension investments typically have three assets: fixed income, property and equity. Fixed income assets (such as bonds or gilts) tend to go down when interest rates rise, so if you’re heavily invested in fixed income you may expect your portfolio to drop in value. Property, as we’ve discussed, also tends to come down in value.

As for equities, when interest rates rise they tend to go up in value. Broadly speaking, when inflation increases, companies charge more for their products; which increases their profits; which means they’re worth more; which increases their share price.

So if you’re heavily invested in fixed income or property in your pension, expect it to fall in value when rates go up; otherwise, an interest rate rise should mean you’ll see your pension continue to rise.

Investors

PensionsIf you’re a low-risk investor, you’re likely to have a majority of your portfolio in fixed interest and bonds, so the interest rate rise will have a negative effect for you.

However, not all fixed interest items act the same (despite what you may have heard): it depends on whether they’re short-term (around three years), medium-term (five to seven years) or long-term (up to 15 years) assets.

When interest rates rise, short-term fixed interest assets are not affected; and medium-term ones only a little so. A more significant impact is seen for long-term loans, because of how bonds work. The longer the time until I’m due to receive my money back from the lender, the more can happen in that time to influence the bond’s price, which will reflect the interest rate in the open market.

Bonds – the basics

Company X is looking for investment, so they launch a bond. You give them £100 for 5 years; they agree to pay you 5% annually, or £5 in this example; and then at the end of the 5 years they give you your £100 back.

Interest rate rises do not affect short-term bonds because you’re going to get your money back in a matter of months or a few years, a timeframe when there are unlikely to be major changes that will affect the value of the bond.

Long-term bonds have much higher volatility – they act like shares – because we can’t predict what’s going to happen over a longer period of time. If interest rates rose sharply from the 5% example above, then you might be able to get 10% interest on a savings account with a high street bank; so why would you want to continue holding your bond? I’d want to sell it and put my money in the bank where I could get £10 annually instead of £5. So the bond price with company X might drop from £100 to £50, because now when I get my £5 annually from the bond, it’s at the same 10% interest rate as I can get in the bank.

Most pension funds are invested in long-term bonds, so their value is likely to go down when interest rates go up.

How Lexo protects your portfolio from interest rate rises

At Lexo, our portfolios are specifically designed to mitigate the effect of interest rate rises, because we only use short- and medium-term bonds in them (and we’re considering removing the medium-term element).

For us, the fixed interest elements are there to reduce volatility, not produce a return – that’s what the stock market elements of our portfolios are for.

Maintain your long-term vision

It’s easy for investors to think, ‘Because stock markets are likely to go up as companies increase profits, even though I’m a low-risk investor, I can see interest rates will rise for the next few years and I don’t want to miss out so I’ll increase my stock market exposure.’

That would be a mistake.

If you’re a cautious investor, your portfolio should always reflect your attitude to loss; how much you feel you can lose. You might want to move away from long-term bonds into more medium- or short-term ones, but your equity exposure should only reflect the amount you’re willing to lose. Roughly speaking, a 100% stock market exposure investment will fall by as much as 50% in the case of a crash.

You shouldn’t get dazzled by any potential returns or the effect you think interest rate rises might have in the future. You should invest in a portfolio that’s commensurate with your level of risk, and just stay invested. As a wise man once said:

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

Paul Samuelson, economist (1915-2009)

Overall, to reiterate: we’re only talking here about a 0.25% increase in the interest rate. These things happen slowly, and that rise won’t have a massive effect. You may not see much change at all in your portfolio for a while yet!

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With investment, your capital is at risk. The value of your portofio with Lexo can go down as well as up and you may get back less than you invest. It is important that you understand the risks. Lexo aims to provide information to help you make your own informed decision. It does not provide personal advice based on your circumstances. If you are unsure, please seek personal advice from Lexington Wealth.

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