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How Falling Interest Rates affect your Finances

The yield on the 10-year benchmark government bonds has fallen sharply by 100 basis points (100 basis points is equal to 1%) to 6.4% per annum, in the last three months. Similarly, the five-year and one-year government bond yields have fallen to 6% plus levels. Fixed deposit and lending rates of banks are directly linked to these rates of the economy.

Few days back, my parents rushed to a nearby bank branch. They wanted to open a bank fixed deposit ahead of a cut in its interest rate. However, the damage was done. A secular fall in interest rates of bank FDs had already lowered their portfolio returns.

The yield on the 10-year benchmark government bonds has fallen sharply by 100 basis points (100 basis points is equal to 1%) to 6.4% per annum, in the last three months. Similarly, the five-year and one-year government bond yields have fallen to 6% plus levels. Fixed deposit and lending rates of banks are directly linked to these rates of the economy.

Why is interest rate falling?

Globally, central banks are cutting interest rates, experts believe, in order to boost the growth rates of their respective economies.

How does it happen?

Lower interest rates make it cheaper to borrow. This in turn tends to encourage spending and investments in the economy. At a lower rate, companies can borrow cheaply from the market to make further investments. Consumer in turn finds EMIs (a function of interest rates) for car and home loans cheaper. These activities boost overall economic activity (or aggregate demand). 

Low interest rates also tend to weaken local currency rates, thanks to flight of capital towards other lucrative currencies. Depreciation of local currency also makes local exports more competitive in the global markets.

All these developments put together have the potential to kick-start the economy and boost its growth rate, at least on paper.

What does a lower interest mean for you?

At the individual level, lower interest rates reduce borrowing rates. So, if you have a floating home loan, you will benefit from lower rates. And if you are taking a car or a student loan, interest rates will be cheaper.

However, the flip side is that your bank fixed deposits will yield lesser. Lower interest rate is bad news for traditional debt-based products. This might affect the spending power of those who depend on them for regular income, especially retirees.

Income booster 

When interest rates are low, businesses can afford to expand, since the capital cost is low and demand from consumer is expected to pick up. This in turn can boost hiring by industries that are positively impacted by the move.

What should you do?

When economies expand, business expands, and their earnings improve. Some sectors do better than others. This has the potential to boost equity markets. So, ensure you are invested adequately in diversified equity funds. It is the best bet to beat inflation and create wealth. Retirees – in turn – should growth-orient their retirement portfolio in favour of equities.

Interestingly, long-term debt funds benefitted from the recent fall in interest rates giving double-digit returns in the last one year. This is because bond (and therefore NAV) prices and interest rates move in the opposite direction. However, with interest rates bottoming out now, debt fund returns are expected to hover around 6%-7%.

Lower interest rates make it cheaper to borrow. This in turn tends to encourage spending and investments in the economy. At a lower rate, companies can borrow cheaply from the market to make further investments. Consumer in turn finds EMIs (a function of interest rates) for car and home loans cheaper. These activities boost overall economic activity (or aggregate demand). 

Takeaway

With FD rates going down, for long term goals, equity remains the best asset class, more so now despite the market turmoil.

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