Coping with Lower Interest Rates

My internet bank lowered their already low rates on balances last week.  I’m not surprised, after all, interest rates on bonds are at record lows.  Unfortunately, this also means that interest earned from bank accounts, CDs and bond funds are also lower, in many cases substantially lower than a couple of years ago.  This is precisely the time that it’s important not to try to over-reach for too much risk to try to make higher returns.  Here’s what I do during times of low interest rates:

–Don’t confuse liquidity needs and return — in other words, if there’s money placed in safe, ready-to-access accounts that might be tapped into or needed for emergencies, a decline in interest rates shouldn’t change this priority.  One of my friend’s Jeffrey got into a financial mess when he took his liquid savings and placed them into a high risk investment account since he thought the paltry returns could be improved.  Unfortunately, he then had to liquidate the high risk investments where they were down in value.  Emergency funds should remain in safe, liquid investments regardless of their yield.

–Be sure that all funds are earning the highest interest possible — if you have large balances in your checking account, see if these can be shifted to a savings account.  If consolidating accounts qualifies you for a higher yield, this may be worth doing.

--Be cautious making large asset allocation decisions when rates are at extremes — although it may seem attractive to place money in higher return areas, risk and return mostly move together.

–Be aware of risks other than the ones you may be accustomed to — during low interest rate environments, I often see new instruments such as guaranteed notes, participation, options, and high yield accounts.  For a sophisticated investor, it may make sense to have some additional options, but my general rule is to have higher risk investments in areas where I’m not concerned about liquidity.

–Read the fine print on special offers — a number of banks and other institutions offer teaser rates which will then reset.  Unless you are very careful and good at maintaining things like this, it may end up costing you net return.

shared at this week’s Carnival of Personal Finance