Rising Interest Rates Can Affect Your Taxes

A few times every year the Fed gathers together. There are rumors that run rampant throughout the finance world that they are raising interest rates this time. So far every meeting has adjourned and the decision has been to leave interest rates alone. But they can’t stay down forever.

When interest rates start to rise, they can have some drastic effects on your taxes. Just how drastic? Read on to learn more about how rising interest rates can affect you.

Interest Rates and You

Every financial transaction that you make is affected by interest rates. From the cost of goods, to how much you earn on your investments, to how much you pay when you carry a balance on your credit card. For the consumer in debt, low interest rates are good. It means you get cheaper credit. For those who have a lot of investments, a higher is better. But if interest rates rise too fast, it can have some severe problems.

Most people think of interest rates and how they affect their loans. If interest rates drop, they can refinance and get a better deal on their loans. That means if you’re stuck paying 6% interest on your mortgage, and the Fed lowers interest rates another time, then you might be able to refinance at 4%. Over the life of the loan, that extra 2% can mean many thousands of dollars.

Interest rates also affect how much you earn when you put your money into savings. If interest rates are high, then you get a better return (many accounts were yielding 5 or 6% before the recession in 2008). That meant your money would grow a lot faster.

Investments in bonds are tied very closely to interest rates. Bonds are in essence giving a loan to a company. Suppose you buy a $1,000 bond with a coupon of 5% (basically it pays 5% interest). Every year the company gives you $50, and at the end of the term (usually 10, 20 or 30 years), you get your $1,000 back. If interest rates drop, and the company can now sell bonds for 3% interest, they will cancel your bond, pay you $1,000, and then sell a new bond to someone for cheaper. The bond market is much more complex than that, but you get the idea.

Investments in the stock market are also tied to interest rates, albeit a little more indirectly. If interest rates go up, stocks that pay dividends know that their dividends are going to have to go up in order to stay competitive. This means that the value of the stock itself will drop a little bit.

Rising Interest Rates and Your Taxes

There’s a quick rundown on how rates affect your investments, savings, and loans. But how do they affect your taxes?

Let’s look at each of those components and see.

Mortgage interest is tax deductible (to a certain amount). That means if you have an adjustable rate mortgage, you are probably paying really low interest right now. If interest rates go up, you will end up paying more in interest on your loan, and you will be able to deduct more off your taxes. Likewise if you take out a new loan, a rising interest rates will mean a larger tax deduction.

Interest earned on a savings account is taxable income. Let’s suppose you are currently earning .5% on $25,000 of savings. That brings in a whopping $125 per year. In a 25% tax bracket you’re looking at roughly $25 in taxes. Rising interest rates make that go up, and if your account starts earning 3.5% interest, you are now getting $875 each year in interest. That same tax bracket means you owe $175 in taxes.

If you have a bond that is paying a lower interest rate than what the market says it should, the value of the bond is going to go down. So if you try to sell your $1,000 bond on the open market, you may only get $850 for it because people know they can get a higher interest rate by paying full price. If you paid $1,000 for a bond, and you sold it for $850, you can deduct $150 from your taxes. Likewise, if you invest in a new bond, all interest is taxable (for corporate bonds at least).

Dividends collected from stocks are taxable. The more the stock pays out the more you pay in taxes. That one is pretty simple.

Practical Taxes is your Affordable Tax Preparer in Billings

Here at Practical Taxes we want to make sure that you know about your taxes. We will prepare your tax return, but we will also give you pointers on how you can lower your tax bill next year. Tax preparation is our specialty, but get in touch with us for all your accounting and bookkeeping needs. Just call 406-894-2050.