STRATEGY SHEET
November 2001
How to Benefit When
Interest Rates Drop
© Talbot Stevens
Although it hurts GIC investors when interest rates drop, businesses, consumers, and investors benefit with falling rates.
Unlike "closed" mortgages, most personal loans can be repaid at any time without penalties. This means that if you have a car loan and rates drop, you can get a new cheaper loan to pay off your old one, and either lower your payments or even better, keep the same payments and pay off the loan faster.
When borrowing, I generally recommend using floating rate loans to automatically benefit instantly when rates drop. As a bonus, loans where the interest rate fluctuates with the prime lending rate often charge the lowest rates.
This concept can also be extended to mortgages. With a variable rate or 6-month convertible mortgage, the interest rate is generally less than longer-term mortgages, and you benefit quickly when rates drop. Remember that if you have a convertible mortgage and rates drop, you can start a new (convertible) mortgage with a 5-minute phone call.
Everyone who is responsible with debt should get a home equity line of credit, and use it to pay down all other loans. A line of credit secured by your home is generally the cheapest source of borrowing possible, usually charging prime.
Investors can benefit when rates drop by understanding the business cycle, and what type of investments to focus on.
When interest rates decrease, it is generally to stimulate the economy. With cheaper financing, it is easier for businesses to operate and for consumers to spend. At the same time, cash-like investments like GICs eventually yield returns that are so unattractive, investors look elsewhere like the stock market. All of these factors help stocks recover.
When rates have dropped and the markets are still low, we are in the bottom of the business cycle. This is a safer time to invest in equities because the economy and stock returns are poised to cycle back through a growth phase.
Before investing in GICs, check the real returns. If a GIC pays 3% interest and you lose a third to taxes, your after-tax return is only 2%. If inflation is 3%, your real return is negative 1%, meaning you are actually losing purchasing power each year.
Consider leveraging conservatively, especially if markets are still low. The safest time to invest in the stock market is when it is down. Therefore, the safest time to start a small, responsible leverage plan is when markets are down. If interest rates are low and dropping, this is a bonus, making it cheaper for investors to "rent" other people's money.
Before investing in bonds, understand how bond prices change. Bond prices go up when interest rates drop, and fall when rates rise. Bonds make the most sense when rates are high and expected to fall.