I don’t know about you, but when I was younger I couldn’t imagine a more boring subject than learning about currency, interest rates and inflation.
What I have come to realize is that I should have learned more about these long ago, especially as they related to my novice investing. Candidly, I would have asked better questions and kept more of my hard-earned money. I studied these topics briefly in college in my economic classes but I did not really understand the relationships. I am finally starting to now, though… it’s never too late. Understanding them can make a serious difference in your financial wellbeing over the period of your lifetime, so it’s definitely worth your time.
I am currently reading a new book by author James Rickards called Currency Wars. He believes the war of money is more than just a concern for economists and investors. He has a compelling book and he is a smart guy. James Rickards advises the Department of Defense, the U.S. intelligence community and major hedge funds on global finance.
My take away from this book is that rising prices are simply one of the effects of inflation. First you have the inflation in the form of an increase in money and credit, and then as an aftereffect we experience rising prices.
Today, the Federal Reserve’s expansive monetary policy is flooding the banking system with cash, diluting the dollar’s value. Take a look at the website for the US Inflation Calculator – it measures the buying power of the dollar over time. You can see for yourself that understanding and watching the value of your money will be well worth your time.
The book goes into detail about the history of money, including when the U.S. prohibited the possession of gold in 1933. It discusses 1971, when President Nixon imposed national price controls and took the United States off the gold standard, an extreme measure intended to end an ongoing currency war that had destroyed faith in the U.S. dollar.
Now that my own hard-earned money is being affected by these topics, I decided I needed to learn more about them. Like I said before, I wish I would have paid more attention in class as I would have made different investment decisions.
Many investors are watching rising real estate values with a sense of urgency to purchase while the deals are still good. However, I would argue that while increasing prices are definitely a motivating factor, rising interest rates are just as, if not more, important to watch. Interest rates are definitely less predictable than rising values and can move in either direction much quicker, as well. As we all witnessed just this last month, any minor shifts in policy or market demand can have a tremendous effect on mortgage interest rates and can affect future returns on an investment on a moment’s notice.
People have asked me why interest rates matter. A modern economy is intrinsically linked to interest rates, thus their importance to the financial markets. Interest rates affect consumer spending. The higher the rate, the higher their loans will cost them, and the less they will be able to buy on credit. This is how it affects inflation. If consumer spending goes down, there will be less demand for products and services, thus prices won’t rise as rapidly. Interest rates are used by central banks as a means to control inflation.
We may not always realize it, but interest rates play an important role in our everyday lives and can greatly affect our buying power. Consequently, the overall trend of interest rates can have a major effect on your investments, thus as an investor, it is important to pay close attention to these trends. Major shifts in direction, be they up or down, should cause you to review present investments as well as point towards potential opportunities.
Keeping abreast of general interest rate trends doesn’t require much time. In fact, it takes mere minutes a week. Key rates, which are important to the investor, are published daily in the major newspapers as well as on most financial websites.
Inflation is the rise over time in the prices of goods and services. Most people automatically think of inflation as a bad thing, but that’s not necessarily the case. Inflation can be the natural byproduct of a robust, growing economy. No inflation, or deflation (the lowering of prices), is actually a much worse economic indicator. Also, in a healthy economy, wages rise at the same rate as prices.
So how do interest rates affect the rise and fall of inflation? Well, lower interest rates put more borrowing power in the hands of consumers. And when consumers spend more, the economy grows, naturally creating inflation. If the Fed decides that the economy is growing too fast – that demand will greatly outpace supply – then it can raise interest rates, slowing the amount of cash entering the economy.
Rising interest rates on real estate and small businesses can seriously affect the overall profit of that business, too. If a business owner’s costs go up because of borrowing, some or all of that cost may be passed on to the customer, which could result in an increase in prices. I came across a great illustration from a blogger of exactly how interest rates can affect a single deal.
For example, let’s say you are getting a loan on an investment property for $100,000 at four percent interest (assuming 20 percent down on a purchase price of $125,000). Your principle and interest payment is going to be about $477, and, for the sake of this example, let’s say your anticipated monthly cash flow from that investment is around $300 per month.
Now, what if you wait to buy this property and interest rates jump a full point to five percent. Your principle and interest payment goes up to $536 a month – an increase of almost $60 per month. Your monthly cash flow now decreases to $240 per month. Do you realize that your monthly cash flow decreased by 20 percent as a result of your interest rate going up by a single percentage point?
Strictly analyzing this from a cash flow perspective, that one percent increase in interest rate is actually the equivalent of that property increasing in value by $15,625 dollars! That’s right, if the property were to increase in price to $140,625 and you were able to get a loan for $112,500 at four percent (again, assuming 20 percent down on a purchase price of $140,625), your principle and interest payment would actually be the same as the $100,000 loan at five percent interest.
Bottom line – in terms of cash flow, that one percent increase in interest rate represents a difference in value of $15,625 dollars in this example! It also represents a 20 percent decrease in monthly returns. So as you can see in this example, rising interest rates can, in fact, rise prices and reduce profit. Rising interest rates could also slow sales. Time will tell on that topic.
What we are doing at MC Companies is still underwriting each deal and looking at the overall five-year returns (yield) on each individual investment. In other words, if we can still make a decent return on our money, we will still invest, generally trying to achieve a 7-10 percent cash-on-cash return.
Today, deals are definitely harder to find and it has been typical for us to be bidding against 20 to 30 other groups. But the formula never changes. You must take into account the price of the asset, the cost of the debt (due to the interest rate) and the profit generated.
We all know that our economy can’t sustain these low interest rates for much longer. We are trying to buy as much as we can and use debt to finance it. Inflation makes those assets worth more, deflation does the opposite. For now, I am betting on a stable currency, rising interest rates and inflation.