Low Interest Rates: Impact On 401(K) Growth

Interest rates play a crucial role in the performance and price of 401(k) investments. When interest rates are low, the premium grows, making stocks more attractive to investors. Lower interest rates also promote economic growth, which boosts corporate profits and stock performance. However, if you own mutual funds that invest in bonds within your 401(k) plan, rising interest rates may lower their share price and net asset value.

Rising interest rates decrease the equity risk premium

Interest rates and inflation tend to move in the same direction. While interest rate moves may lag changes in the inflation rate, they generally move in tandem over time.

Rising interest rates also prompt savers to re-examine their investment portfolios and asset allocation. A long period of low interest rates can steer many people away from low-yielding bonds, savings accounts, and certificates of deposit and toward dividend-paying stocks that offer higher returns.

When interest rates rise, it probably makes sense to start looking at selling off some of those assets and moving back toward bonds. If you’re too heavily weighted in equities and you’re coming toward retirement—and we have another situation where the market crashes—you’re going to lose a lot more.

Bonds may start to look more attractive to savers nearing retirement, as bond yields commonly rise when market interest rates increase.

Lower interest rates influence the 401(k) loan choice

Loans from 401(k) plans represent a trade-off between the interest rate that would be paid on a bank loan and the return expected to be earned on the 401(k) investments. A 401(k) loan is preferable only if the interest rate exceeds the expected return of the 401(k) investments. Origination and maintenance fees combined with small loan amounts dramatically increase the cost of 401(k) loans.

When interest rates are low, the premium grows, and taking the risk on stocks becomes more attractive. Lower interest rates promote economic growth, while the increased borrowing costs associated with higher rates tend to slow it. Because corporate profits are correlated with economic growth, lower rates provide a tailwind for stocks, while higher ones can slow profit growth and hold down earnings multiples.

A long period of low interest rates can steer many people away from low-yielding bonds, savings accounts, and certificates of deposit and toward dividend-paying stocks that offer higher returns. When interest rates rise, it probably makes sense to start looking at selling off some of those assets and moving back toward bonds. If you’re too heavily weighted in equities and you’re coming toward retirement—and we have another situation where the market crashes—you’re going to lose a lot more.

The interest rate and the investment return are the most important factors influencing the 401(k) loan choice. The relevant interest rate is the rate that would be paid if a 401(k) loan was not used. The rate of a 401(k) loan is typically lower than the rate of similar loans. The difference in payments provides savings to the borrower. The choice for the borrower is whether the investment return is expected to be higher than the lowest available market rate. If the investment return is expected to be higher, a 401(k) loan is a poor choice.

High interest rates lower the price of mutual funds

Rising interest rates decrease the equity risk premium, which is based on the risk-free rate of return, typically the yield of the 10-year Treasury note. Fixed-income investments such as bonds and CDs with higher rates present more competition to stocks for the investment dollar, because the premium or amount of return over fixed-income offered by stocks is smaller, and therefore less worth the risk. Conversely, when interest rates are low, the premium grows, and taking the risk on stocks becomes more attractive.

If you own mutual funds that invest in bonds inside your 401(k) plan, a rise in interest rates will likely lower their share price and net asset value. On the other hand, the income of these funds would likely rise over time as they add new holdings paying higher rates to their portfolios.

Interest rates also play a key role in the price and performance of equity markets. Lower interest rates promote economic growth, while the increased borrowing costs associated with higher rates tend to slow it. Because corporate profits are correlated with economic growth, lower rates provide a tailwind for stocks, while higher ones can slow profit growth and hold down earnings multiples.

One way that interest rates affect retirement plans is by prompting savers to re-examine their investment portfolios and asset allocation. A long period of low interest rates can steer many people away from low-yielding bonds, savings accounts, and certificates of deposit and toward dividend-paying stocks that offer higher returns, Dulin says. “When interest rates rise,” according to Dulin, “it probably makes sense to start looking at selling off some of those assets and moving back toward bonds. If you’re too heavily weighted in equities and you’re coming toward retirement—and we have another situation where the market crashes—you’re going to lose a lot more.”

Bonds may start to look more attractive to savers nearing retirement, as bond yields commonly rise when market interest rates increase.

Low interest rates prompt savers to re-examine their portfolios

Rising interest rates decrease the equity risk premium, which is based on the risk-free rate of return, typically the yield of the 10-year Treasury note. Fixed-income investments such as bonds and CDs with higher rates present more competition to stocks for the investment dollar, because the premium or amount of return over fixed-income offered by stocks is smaller, and therefore less worth the risk. Conversely, when interest rates are low, the premium grows, and taking the risk on stocks becomes more attractive.

Interest rates and inflation tend to move in the same direction. While interest rate moves may lag changes in the inflation rate, they generally move in tandem over time.

One way that interest rates affect retirement plans is by prompting savers to re-examine their investment portfolios and asset allocation. A long period of low interest rates can steer many people away from low-yielding bonds, savings accounts, and certificates of deposit and toward dividend-paying stocks that offer higher returns, Dulin says. “When interest rates rise,” according to Dulin, “it probably makes sense to start looking at selling off some of those assets and moving back toward bonds. If you’re too heavily weighted in equities and you’re coming toward retirement—and we have another situation where the market crashes—you’re going to lose a lot more.”

If you own mutual funds that invest in bonds inside your 401(k) plan, a rise in interest rates will likely lower their share price and net asset value. On the other hand, the income of these funds would likely rise over time as they add new holdings paying higher rates to their portfolios. Interest rates also play a key role in the price and performance of equity markets. Lower interest rates promote economic growth, while the increased borrowing costs associated with higher rates tend to slow it. Because corporate profits are correlated with economic growth, lower rates provide a tailwind for stocks, while higher ones can slow profit growth and hold down earnings multiples.

Loans from 401(k) plans represent a trade-off between the interest rate that would be paid on a bank loan and the return expected to be earned on the 401(k) investments. A 401(k) loan is preferable only if the interest rate exceeds the expected return of the 401(k) investments. Origination and maintenance fees combined with small loan amounts dramatically increase the cost of 401(k) loans. Borrowers may reduce their deferral rate to offset loan payments. Tax consequences in the event of default, usually due to job loss, and bankruptcy protection may also diminish the appeal of 401(k) loans. Loans taken from 401(k) plans are preferable when used as an alternative to high-interest rate debt.

The relevant interest rate is the rate that would be paid if a 401(k) loan was not used. The rate of a 401(k) loan is typically lower than the rate of similar loans. The difference in payments provides savings to the borrower. The choice for the borrower is whether the investment return is expected to be higher than the lowest available market rate. If the investment return is expected to be higher, a 401(k) loan is a poor choice.

Interest rates represent a trade-off for 401(k) loans

Interest rates and inflation tend to move in the same direction. While interest rate moves may lag changes in the inflation rate, they generally move in tandem over time. Rising interest rates decrease the equity risk premium, which is based on the risk-free rate of return, typically the yield of the 10-year Treasury note. Fixed-income investments such as bonds and CDs with higher rates present more competition to stocks for the investment dollar, because the premium or amount of return over fixed-income offered by stocks is smaller, and therefore less worth the risk. Conversely, when interest rates are low, the premium grows, and taking the risk on stocks becomes more attractive.

One way that interest rates affect retirement plans is by prompting savers to re-examine their investment portfolios and asset allocation. A long period of low interest rates can steer many people away from low-yielding bonds, savings accounts, and certificates of deposit and toward dividend-paying stocks that offer higher returns, Dulin says. “When interest rates rise,” according to Dulin, “it probably makes sense to start looking at selling off some of those assets and moving back toward bonds. If you’re too heavily weighted in equities and you’re coming toward retirement—and we have another situation where the market crashes—you’re going to lose a lot more.

If you own mutual funds that invest in bonds inside your 401(k) plan, a rise in interest rates will likely lower their share price and net asset value. On the other hand, the income of these funds would likely rise over time as they add new holdings paying higher rates to their portfolios. Interest rates also play a key role in the price and performance of equity markets. Lower interest rates promote economic growth, while the increased borrowing costs associated with higher rates tend to slow it. Because corporate profits are correlated with economic growth, lower rates provide a tailwind for stocks, while higher ones can slow profit growth and hold down earnings multiples.

The relevant interest rate is the rate that would be paid if a 401(k) loan was not used. The rate of a 401(k) loan is typically lower than the rate of similar loans. The difference in payments provides savings to the borrower. The choice for the borrower is whether the investment return is expected to be higher than the lowest available market rate. If the investment return is expected to be higher, a 401(k) loan is a poor choice.

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