While some interest rates have increased marginally in recent months, across the board they remain lower than has been seen in a number of years. In addition, Federal Reserve Chairman Jerome Powell said at their March 2021 meeting that he does not expect rates to hike until most likely 2023.1
All of this potentially presents appealing opportunities for both lending and borrowing in different circumstances. Whether deciding to take advantage of low rates to make a large purchase, refinance existing debts or lend to help a family member with major financial endeavors, there is a wide range of personal considerations to take into account.
Why Spend When You Can Borrow?
One of the many advantages of having a robust cash reserve is the ability to spend when you need or want to, without having to concern yourself with financing, interest rates and repayment schedules. Conventional wisdom often says that paying cash if you can, and avoiding the costs and hassle of financing, is ultimately a better value. But now, the low interest rate environment we’ve been operating under the past few years gives us reason to pause and consider whether financing might make more sense.
When low interest rates are available, as is often the case recently, the cost of financing may be of less significance than the opportunity cost associated with decreased cash on hand. This is typically not the case with smaller purchases, however, for significant purchases like new homes, major home renovations or luxury vehicles, the advantage of retaining access to that cash can be worth the relatively minimal cost of financing. Just because you have the cash on hand, it doesn’t mean that using it to fund a large purchase outright is the best way to deploy a limited resource.
For instance, consider a situation where you’re planning to purchase a new vacation property for your family. Say you have the cash reserves available to buy the home outright, but it would put a significant dent in those reserves to do so. Some months later, you need to fund a capital call for a new investment opportunity. Because you paid cash for your new vacation home, the cash is not available to fund the new investment, so you must decide to either forego the opportunity or sell from another part of your portfolio to raise the necessary cash. Given current interest rates for a 30 year fixed mortgage are around and can even be under 3% and are around 2% for a 15 year fixed mortgage2, if the investment opportunity would likely provide returns above those rates, there is a good likelihood that taking on the debt to finance your new home would actually leave you with a net gain relative to purchasing outright. Just because you have the cash on hand, it doesn’t mean that using it to fund a large purchase outright is the best way to deploy a limited resource.
In instances like this, it’s important to remember that not all debt is created equal. Predictable, secure debt with low interest rates like mortgages has a very different impact on your financial picture than unsecured, high interest debt like credit card balances. If you have other opportunities for the same cash, taking advantage of financing options can make perfect sense.
Rates are low, but not all rates are created equal
Interest rates can be influenced by a range of different factors, depending on the type of rate. Different types of loans are influenced by federal rates to different degrees, and are influenced by two different federal rates, the Federal Funds Rate, which helps determine the prime rate, and the Applicable Federal Rate (AFR). These rates are based on different economic and monetary benchmarks and serve different purposes, so they may not necessarily move in lockstep, particularly in a time like we’ve experienced recently when the economy writ large is in a state of flux.
It is worth noting that particularly for fixed rate mortgages, a number of factors aside from federally determined interest rates contribute to the rate that an individual borrower is offered, including bond market performance and borrower demand. Adjustable rate mortgages are likely to move more closely in line with the prime rate, but fixed mortgage rates often take some time to move after federal rate adjustments and may move little if at all depending on other market factors.
As the chart below illustrates, these various interest rates do follow similar broad trends but may not always move at the same time or to the same extent, thanks to their disparate uses and methodology.
Interest Rate Changes Over Time
Regardless of which interest rates you’re looking at, we are experiencing a notably low rate environment that has been ongoing and appears likely to continue for some time as the economy progresses through a post-COVID-19 recovery. While you may have taken advantage of low rates over the past year, it’s worth noting that rates are still very low and seem likely to remain that way for at least the immediate future.
Taking Advantage of Historically Low Rates
With the understanding that rates are as low as we’re likely to see them for a significant time, there are several options you may want to consider to take advantage of the situation. Whether taking on new debt while it’s at an appealing cost or refinancing existing obligations, these are often complex transactions, and it’s important to consider both the cost of the financing and how much the effort in terms of logistics, paperwork and working with attorneys and other professionals is worth.
When to Refinance
- There is still a significant portion of the original debt left to pay off. If the balance is small, it may be better to simply pay off the balance instead.
- The current rate is significantly higher than the rate at which you could refinance. If your current rate on a debt is only somewhat higher than the rate you’d be offered to refinance, it may not be worth it when you consider the effort and costs associated with refinancing.
- You’re comfortable with a lender who would offer you a competitive rate. Often refinancing can mean moving your debt to a new lender, and if you’re not happy with who your new lender could be, refinancing might not be in your best interest.
Buy While Financing is Affordable
Aside from the more obvious options of making planned major purchases like homes or vehicles, now may also be a good time to establish new loans or lines of credit to provide yourself an additional source of emergency cash or take on projects like renovations or business expansions at a lower cost. Home equity lines of credit may be particularly appealing to some as they allow you to establish a line of credit and set the terms now while rates are low without actually having to take advantage of those funds until you need them. If you find that you never need to use the line of credit, you never actually take on any debt, but you have the option available should you need it, even in the future when rates may be significantly higher.
Drive Down Cost of Existing Debt
For existing debts like mortgages or outstanding loans of other types, refinancing may be a way to cut down the cost of that debt by taking advantage of the current more favorable interest rates. Some lenders may also be able to offer you an amendment or modification to your existing mortgage, which can be a less complicated process than a full refinancing. As we’ve said, this process is not without some cost in terms of time and potentially fees to attorneys, CPAs and other professionals. Still, particularly for debts that originated years ago when rates were orders of magnitude higher, it can be well worth the savings. Your primary considerations on whether to refinance are generally going to be how much of the original obligation is left to pay off, and the difference between the current rate and the rate that would be available were you to refinance.
The Family Bank May Make More Sense Than Ever
Intrafamily loans are a particularly compelling option in times of extremely low interest rates. Loans between family members, typically between parents and children, are heavily scrutinized by the IRS due to the sometimes significant tax implications and the low federally determined rates that make these loans much more cost-effective for borrowers. For the IRS to consider a loan legitimate and not effectively a gift, the loan must carry an interest rate of at least the relevant AFR given the term of the loan and payments must be made according to the agreed-upon repayment schedule.
With AFRs currently close to zero for some terms, it could be a good time to originate a loan to help a child with major financial undertakings like purchasing a home or starting a business or paying down significant debt like student loans. If you have an existing intrafamily loan, you may also be able to refinance that loan at the current rate and lower your child’s payments and the loan’s overall cost burden.
Intrafamily loans can also be an effective estate planning tool, as it removes assets from what would be included in your estate while allowing your children to benefit. For example, suppose you were to provide a loan to your children for them to take advantage of an investment opportunity. In that case, the gains on that investment would likely far outpace the AFR that you would be required to charge them and would be free of gift or estate tax implications.
We discuss the nuances of intrafamily loans more in our article here.
The current low interest rate environment can present opportunities for a wide range of circumstances and needs. Still, as with so many parts of financial planning, your choices are highly individual. Your Wetherby team is happy to discuss your options and offer guidance however possible.
1CNBC. Recap and analysis of Fed Chairman Powell’s market-moving comments on rates. March 17, 2021. https://www.cnbc.com/2021/03/17/fed-meeting-live-updates-watch-jerome-powell-speech.html
2Bankrate. March 19, 2021. https://www.bankrate.com/