Strategic Uses of Credit Before Interest Rates Rise

The Federal Reserve has been slow to increase rates, so there's still time to use credit to help achieve financial goals.

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The Federal Reserve has maintained historically low interest rates for so long that it's easy to feel complacent. When the Fed raised its target rate in December 2015, many thought it would be followed by a steady stream of rate increases to tighten monetary policy. But now, Wells Fargo Investment Institute expects only one rate hike before the end of 2016.

At some point, however, the inevitable is going to happen: interest rates will start rising. Are you prepared?

It's a good idea to talk to your financial team now about how to manage interest rate risk and take advantage of these historically low borrowing costs before rates increase, says Sean Faeth, Managing Director of Product Strategy at Wells Fargo Private Bank.

The cost of waiting
It may be tempting to attempt to "time" interest rate movements, much like some investors try to time the market, but this can be risky, says Faeth. Analysts expect both short- and long-term interest rates to rise over time, and the key questions are when and at what pace. The Fed primarily considers economic growth, the unemployment rate, and inflation indicators in its policymaking decisions. Consumer and business confidence, international economic conditions, adverse supply or demand, and economic shocks such as those that arise from energy price volatility may also come into play. 

"Since it is difficult to know which economic markers the Fed will deem most important, we really don't know when rates will increase," Faeth says. "It is fair to say, though, that it is not a question of 'if' but rather a question of 'when' rates will rise."

It may be tempting to attempt to "time" interest rate movements, much like some investors try to time the market, but this can be risky.

Now is the time to consider what the impact would be on your wealth plan if rates rise 1 percent or more, and to talk through steps you can take today to proactively manage any risks from rising rates, he says. 

"The reality is that waiting may have a real cost," Faeth says. "Even small changes in interest rates may have a material effect on future borrowing costs."

"If you have a floating rate loan or a loan against commercial real estate or some other asset that's going to be maturing in the next six to 12 months, you may want to look into refinancing now to take advantage of the current rate environment," Faeth says. "Exploring these options may help you secure more favorable terms or fix the interest rates associated with the borrowings. These strategies can be fairly basic to more complex depending on your financial objectives."

Using credit as a means to an end
The strategic use of credit may help you accomplish several different financial objectives, Faeth notes. Here are a few to consider:

  • Finance significant purchases. When the opportunity to acquire an investment or other major asset comes along, often the first thought is whether you have sufficient cash on hand. Using credit to finance the purchase instead may offer potential advantages, such as providing a lower cost option, preserving cash reserves, and avoiding a disruption to investment goals.
  • Help optimize cash flows. Do you have uneven income streams? Borrowing can help you smooth out the variability in your cash flows over time. One option is to talk to your banker about a loan or line of credit to enhance financial flexibility. If rising rates are a concern, borrowing costs can be insulated from rate increases by securing a fixed-rate advance on a floating-rate home equity loan or by using interest rate hedging strategies on all or a portion of larger floating rate loan exposures, such as commercial real estate loans.
  • Take advantage of potential tax savings. If you're planning to make a large purchase — buying some commercial property or a vacation home, for example — instead of selling off some investments and potentially triggering long-term capital gains or other taxes, you can use a line of credit to borrow against those same investments to fund the purchase.
  • Align with your investment objectives. Managing your cash flow through credit may help take advantage of timely opportunities as they arise. Securities-based borrowing, for example, can help you be more nimble in making adjustments to your portfolio by providing access to cash when you need it, potentially at lower rates than other forms of credit. That access may give you the flexibility to make an investment when conditions are right for you, or add an asset class that provides greater diversification, potentially reducing your overall portfolio risk. 
  • Address estate planning goals. Credit can play a role in wealth transfer where personal and business assets are concerned, whether your goal is to transfer assets to your children without reaching the lifetime gifting ceiling under IRS rules or to help smooth out succession planning for your family-owned business. Talk to your financial team about how borrowing can be an important tool in establishing grantor-retained annuity (GRAT) or charitable lead annuity (CLAT) trust structures or in helping to protect your cash flow while funding key expenses, such as life insurance premiums that support estate planning goals. 

Ultimately, it's important to work closely with your legal, tax, and financial team of advisors to determine if these strategies make sense for you," Faeth says. "By planning ahead, you can mitigate risk. No matter what you decide, you want to be proactive about understanding your exposure and taking action when appropriate."

Michelle Crouch writes about consumer finance, parenting, and more from her home in Charlotte, North Carolina. Her work has appeared in Reader's Digest, Parents magazine, and The New York Times.

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