The following column appears in the Summer 2010 issue of Financial Partner magazine:
Thoughts on Interest Rates
The feature article in this issue of Financial Partner magazine is about interest rates. Will interest rates go up? Should borrowers consider switching from variable to fixed interest rates? Members asked similar questions at our recent annual meetings.
Yankee’s variable interest rate depends on what happens in the short-term interest rate markets. Short-term interest rates are at historical lows. They have no place to go but up—the question is when and how much.
Yankee’s fixed interest rates depend on what happens in the long-term interest rate markets. Long-term interest rates are also low, but they are not at historical lows. Recently they have been declining. (But this could change by the time you read this.)
As I write this, our Tier 1 variable interest rate is 4.00%. The 10-year fixed rate for a Tier 1 borrower is 6.20% today (this rate can change daily). Should this borrower choose the variable or the fixed rate?
Let’s first consider short-term rates. As noted in the feature article, the consensus opinion is that short-term rates will likely increase, perhaps significantly, sometime in the near future. This is what I think, too, but it is worth noting that this is not certain. Short-term rates in Japan have remained low for the past 15 years! Here in the U.S. we are less than two years into our present period of low short-term interest rates.
Now let’s consider long-term rates. There is no consensus opinion on whether long-term rates will increase or decrease over the next few months. The Wall Street Journal recently published the results of a survey on this question. Of the 18 forecasting teams surveyed, 14 predicted an increase and four predicted a decrease. As noted above, the minority has been right so far—the long term rate in question has been declining.
If you think short-term rates will increase significantly in the near future, and you think that long-term rates are also going to increase, you might be inclined to switch to a fixed rate now. But if you think long-term rates are going to decrease, you would probably stay with a variable rate for now. Why fix now if you think you can fix later for less? And, of course, if you think that short-term rates won’t increase all that much, at least for a while (e.g., the Japan scenario), then you would probably stay with the variable rate.
Well, this is all getting complicated! It reminds me of a quote attributed to the famous Danish physicist Niels Bohr: “Prediction is very difficult, especially about the future.”
My advice is to make your own prediction. Your prediction is likely to be as good as mine or anyone else’s, even the experts. Keep in mind that even the experts don’t agree on predictions for long-term interest rates. And when the experts do all agree, as in their prediction that short-term interest rates will increase in the near future, they could still be wrong.
The important thing is to make decisions that you can live with, even if your prediction is wrong. As noted in the feature article, this depends on your personal tolerance for volatility and your financial condition.
And keep in mind that the most important decision a borrower makes about credit is not whether to choose a fixed or variable interest rate. It is deciding how much to borrow.
Click here for the complete Summer 2010 issue of Financial Partner magazine (3 MB PDF file).
See also the next post (More Thoughts on Interest Rates) for additional information and links.
