How to adjust your borrowing, saving and investing as interest rates continue to decline

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USA TODAY personal finance reporter, Janna Herron, explains how changes in the Federal Reserve’s interest rates affect your financial accounts. USA TODAY

Interest rates have been declining for most of the past decade, and yet, the low-rate trend looks like it could persist for quite a while longer.

The Federal Reserve just cut short-term interest rates amid signs of economic slowing. Consequently, it’s not a bad idea to assess your exposure to low rates and your opportunity to capitalize on them, when it comes to borrowing, saving and investing.

Rates on some types of loans are dropping again, and that can make it enticing to go out and borrow more money to purchase all sorts of things — homes, vehicles, appliances or whatever.

Borrowing: Don’t overdo it

Financial adviser Daniel Hill of D.R. Hill Wealth Strategies in Richmond, Virginia, suggests caution. “People tend to overextend themselves, which is what happened” prior to the Great Recession about a decade ago, he said.

If you must borrow, Hill suggests being careful not to extend your terms. Loans going out six or seven years on vehicles, once unthinkable, have become common. Lengthy payback periods could be a sign you can’t afford the item otherwise. Besides, you would be locking in payments for many years on assets, like cars and trucks, that will lose a substantial amount of value over that time.

Low rates do provide an opportunity to refinance existing debt and even use it to pay off higher-cost loans.

Neal Van Zutphen, a certified financial planner at Intrinsic Wealth Counsel in Tempe, cites two common rules for refinancing a mortgage. If you can offset your loan closing costs with lower monthly payments within a year or so, refinancing could be worthwhile. So, too, if you can shave at least half a percentage point on your interest rate.

The interest rates on mortgages are among the cheapest forms of borrowing and thus can be a shrewd way to pay off more costly loans such as credit-card balances. You just don’t want to squander the proceeds on vacations or other unnecessary spending.

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Saving: Expand into riskier options

Savers have been hurt by the trend toward drastically lower rates over the past decade or so. Nor will they get much help in the form of higher yields anytime soon. In fact, yields on certificates of deposit, money market funds and other short-term instruments have started to ebb in the wake of the Fed’s latest rate cut.

To generate more yield, you might need to venture into investments that carry at least some principal risk, such as short-term bonds and bond funds. The longer the term on a bond, the greater the possibility that prices could drop if interest rates rise. Conversely, longer-term bonds will enjoy more capital appreciation if rates fall further.

If you’re depending on yield to make ends meet, it might be time to consider stocks and stock funds. Sure, you face volatile prices, but hundreds of stocks now are yielding 2% or more, with dozens in the range of 4 to 5% or higher.

That means these dividends exceed the interest paid on many types of bonds, including federal government bonds and municipal issues sold by cities, counties and state agencies.

Conservative stock holdings, such as dividend-paying companies, are a logical extension along the risk scale that starts with deposit accounts and money-market funds and extends to short-term bonds and then longer-maturity bonds.

“You just need to have different buckets of money” for diversification purposes, said Hill.

Money held in checking accounts, money-market funds and other highly conservative instruments earn the least, but you need some ready cash to meet emergencies.

Dividends: Red flags for reductions

If you decide on conservative stock holdings, don’t get too greedy. An abnormally high dividend yield could signal that a corporation could be getting ready to cut the payout.

Companies don’t like to reduce or eliminate dividends but might need to do so. Red flags for an impending dividend cut include declining revenue and cash flow, rising debt and deteriorating business conditions.

Diversifying among high-dividend stocks, in a fund or otherwise, can mute the fallout if one or a couple companies cut their payments.

Van Zutphen likes to focus on the “payout” ratio or size of annual dividend payments in relation to yearly earnings. Payout ratios above 100%, where a corporation spends more on dividends than it generates in net income, represent an unsustainable situation. But even ratios above 70% can be worrisome, he said.

One notable exception are REITs or Real Estate Investment Trusts, which typically pay out nearly all of their cash flow to qualify for an unusual benefit (their income isn’t subject to corporate income taxes). No wonder these stocks tend to sport high yields.

Van Zutphen favors companies with a history not just of paying dividends but increasing them. Many of these corporations are included among the “dividend aristocrats” tracked by S&P Dow Jones Indices. All 57 companies on this aristocrats list have boosted their dividends annually for at least 25 years.

Combined, the aristocrats currently pay an average dividend yield of 2.5%. Examples include Cincinnati Financial, Cintas, Medtronic, Air Products & Chemicals, Abbott Laboratories and Procter & Gamble.

Retirement: Look to ease pressures

Low interest rates also can affect your retirement strategies.

For example, you can increase your monthly cash flow considerably by holding off on Social Security benefits. Once you claim Social Security, you lock in the same income stream for the rest of your life, increased by any COLA or cost-of-living adjustments.

If you haven’t yet claimed benefits, you can boost the monthly amount each year you delay, up to age 70.

The tradeoff to waiting is that you would be forsaking Social Security payments received at an earlier age. But if you’re concerned about outliving your money and expect to live to a fairly old age, delaying can be a smart strategy.

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Social Security paid a 2.8% COLA for 2019, but inflation has slowed. The next increase could be closer to 1%, assuming the recent inflation trend persists. The Social Security Administration will announce the new rate in October, following release of relevant inflation numbers: The next COLA will be pegged to the change in CPI-W, the consumer price index for urban wage earners, from the third quarter of 2018 to the same period in 2019.

Persistently low interest rates can be a reason to delay retirement, if you fear cash flow might be a problem. The longer you stay employed, the less work your investment portfolio must shoulder to help you make ends meet.

In fact, remaining in the workforce even an extra year or two could be the biggest step you can take to improve your retirement readiness.

Low interest rates — and low investment returns generally — also are a reason to sock away more cash in workplace 401(k) programs and other retirement accounts.

“You might need to reassess how much more you might need to save to hit your goals,” said Van Zutphen. “You might need to save more.”

Reach Wiles at russ.wiles@arizonarepublic.com or 602-444-8616.

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