From mortgages to savings, interest rate hikes have varying impacts – The Royal Gazette

This is the fourth in a series of articles written as part of Financial Literacy Month.

Today we look at current financial impact concerns about inflation minimization strategies exercised by our three largest neighbours: the Federal Reserve in the US, the Bank of England in the UK United and the European Central Bank in the European Union.

All financial authorities, to varying degrees depending on the state of their economies, responded by raising interest rates, quantitative easing and related economic management tools.

Uptrend: Interest rate increases by central banks around the world are expected to make variable rate mortgage holders pay more

Why is inflation control necessary now?

Simple answer: there is more demand for goods and services than supply. Some, but not all, causes are:

• An increase in the money supply (known as “easy”)

• After years of relatively cheap and available energy, a decrease in the production of goods and services, for example due to the ripple effects of destructive forces during the invasion of Ukraine

• Global supply chain pandemic crises (toilet paper hoarding is famous)

• Pandemic relief programs

• More borrowing and debt spending

• Rising wages put pressure on prices

• Factors all contributing to the highest inflation rates in decades.

The end result is that households, industries and economies see higher prices.

Impact of Inflation on Finances and Investments

Species: purchasing power declines. Goods and services cost more across the board, while the value of the same dollar used is reduced. The CPI (Consumer Price Indices) tracks price trends closely, for example the US CPI shows that $100 for household consumption in 2017 now costs $118.39.

Savings: savings already in the accounts may have riders that raise interest rates in line with central bank hikes.

New savings, term deposits, etc. will pay higher amounts, assuming local banks follow global banking models. Now may be the time, if savings rates are rising, to create term deposit ladders. I will write more about this in a future article.

Debt: Government of Bermuda loans, mortgages, credit cards and notes. When the US Federal Reserve raises the discount rate applied to banks, these institutions in turn pass the increase on to consumers.

New mortgages, lines of credit, and possibly credit cards, etc., will be offered at higher lending rates. Internationally, banking institutions in other countries tend to be in tandem.

For homeowners and other mortgage holders, the impact will depend on the terms of your loan.

Existing fixed interest rate mortgages and loans – in place – issued for the full term to maturity – will not see interest rate changes.

However, existing adjustable interest rate mortgages – in place – and any other loan with these interest terms are very different. Your interest rate is not fixed!

Anyone who has borrowed on this platform should check their contract very carefully because as interest rates rise across our banking economic spectrum, so will the cost of your mortgage.

There are two ways to handle this:

1, your bank will charge you the same amount each month, but the principal allowance will be less and conversely the interest allowance will be greater.

2, the alternative is that your monthly payment will increase, due to the increased interest rate.

Generally, if your bank/financial institution offers it, you may be able to convert your mortgage to a fixed rate for its remaining life.

However, there will most likely be additional costs involved for the conversion; the interest rate may still be higher overall; and, not being able to predict the future, interest rates may fall faster than expected, in which case the cost of conversion may not make financial sense.

Loans and credit card agreements should also be carefully considered. The lender may have the right to raise interest rates without notice, like a floating rate note, or possibly the right to call the note in order to issue a new loan at a higher rate.

Government bonds: a reader asked what would happen if at the end of the term of any government borrowing, or upon renewal, the government had to pay higher interest rates?

A very pertinent question, thank you, John Joseph.

As part of the Bermuda Stock Exchange Fixed Income List for the Government of Bermuda, a number of senior notes are due to be repaid in principal in 2023. We will be looking at the first maturity, namely senior notes rank at 4.138%, due January. 3, 2023, for $475 million issued on July 3, 2012 (click here link to see the tender offer of August 10, 2020, https://tinyurl.com/bddsj7n9)

Disclaimer: Please keep in mind that the following are only guesses. I do not have access to inside information and the full contract, so another caveat, none of these possibilities may apply.

There could be many outcomes and varying interest rates depending on the structure of the tender offer. This note appears to be priced at a premium above par, so at maturity the principal repayment may be slightly less than the investor’s purchase price.

• First, consider the interest rate environment at the start of 2023

• Generally, if global interest rates have risen/continue to rise, a higher interest rate is needed for a new offer to entice investors to participate

• Possibly a rollover of the existing note, again with a more contemporary interest rate in the offer

• A payment of the due note and an entirely new tender offer, with an interest rate reflecting the credit rating and interest rates at the time

• The details of a new contract offer could allow the investor a sell provision if the interest rate is not as competitive. Search “bond sale offer”.

Money market UCITS: these are generally high quality short-term debt securities, commercial paper and cash equivalents, all within nine months of maturity. Highly liquid, their underlying securities revolve around prevailing interest rate changes. Interest rates are low now, but they will rise as prevailing rates rise – remember that money market mutual funds were paying around 6% in 2007, before the subprime mortgage crash.

To be continued.

Fifth part: final article on the impact of inflation on stocks and other investments, April 30.

Sources

House of Commons Library: Interest Rates and Monetary Policy: Main Economic Indicators, April 14, 2022, https://commonslibrary.parliament.uk/research-briefings/sn02802/

Consumer Price Index in the United States April 12, 2022, https://www.bls.gov/news.release/cpi.nr0.htm

Martha Harris Myron JSM is from Bermuda and has connections to the United States. She is an Amazon/Apple published author of Dawn of New Beginnings, Book One of The Bermuda Islander Financial Planning Primers. Contact: [email protected]


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