How to Profit From Higher Interest Rates

Andy Obermueller's picture

Friday, July 24, 2009 - 6:06pm

by Andy Obermueller

Art Laffer is the dean of supply-side economics, which holds that the key to any macroeconomic ill is to let people keep their money rather than to tax them. I agree. So did President Reagan, whose landmark tax cuts in the early 1980s were inspired by Laffer.

Laffer published a piece in the Wall Street Journal last month predicting increasing inflation and higher interest rates. His argument centered on recent actions by the Federal Reserve that boosted the nation's money supply. It was a dramatic move, an unprecedented action. "The percentage increase in the monetary base is the largest increase in the past 60 years by a factor of 10," Laffer wrote. That on top of trillions in new government spending will have consequences.

What will they be? "We can expect rapidly rising prices and much, much higher interest rates over the next four or five years." Laffer couldn't quantify just how bad things would get. "It's difficult to estimate the magnitude of the inflationary and interest-rate consequence of the Fed's actions because, frankly, we haven't ever seen anything like this in the U.S."

When a world-class economist like Laffer makes a prediction like that, it gets me to thinking. And my first thought was -- of course -- how I could profit from it. How could I use inflation and higher interest rates to my benefit to increase wealth? Is that even possible?

Sure. And not just in an economics class.

There's a lot of wealth in this country just sitting around, doing nothing. I'm not just referring to uninvested cash sitting on the market's sidelines. Take the equity in your home. Nationwide, home prices are growing very slowly and, in most cases, are only making up lost ground. Yet your home is most people's largest investment. Would you hold onto a mutual fund with such an anemic return? Not in a million years! You'd allocate that capital to something that offered better performance.

You can do that with your home. And you don't even have to move out of it. You see, your equity is portable. You can pick it up and move it. And you should consider precisely that.

If you have good credit, you can take out a home equity loan for about 5%. Say for argument's sake you had $250,000 equity in your house. You borrow $200,000 of it at 5%. You invest in a good tax-free bond. The composite rate on the 20-year AAA muni is 5.24%. So this is a good way to tread water: Your interest collected is greater than your interest cost. The plan has tax advantages, too: Not only is the interest not taxable, but the interest you pay on your home equity loan is tax deductible. For a household with $85,000 a year in taxable income, this $10,000 would save about $2,800 in taxes.

The trick after locking in a low rate on a home-equity loan is to move your money into higher yielding instruments as they become available. If Laffer is right and rates return to the 20% range of the early 1980s, then an investor might well decide to put his $200,000 into a CD paying 17%.

In that scenario, the investor would pay $10,000 a year in interest on the home-equity loan while collecting $34,000 in interest from the CD, leaving a spread of $24,000. The $34,000 in interest income would be taxed at 28%, which translated into a gross tax bill of $9,520. That would be offset by the $2,800 in tax savings from the mortgage-interest tax deduction, or a net tax cost of $6,720. After paying the interest and taxes, the borrower would have earned $17,280, or a net 8.6% -- far better than the market has done in the past ten years, and with FDIC insurance.

Absent a huge and lasting drop in home prices, there's infinitesimal downside to this plan: You're earning a little cash and getting a tax break in the worst case scenario, you're profiting from a huge interest rate spread in the best case scenario. But you can't wait. You've got to lock in the low rate now and profit from the increased spread later: If CD rates rise, which is your income, then so will borrowing rates, which is your cost.

If higher interest rates and inflation are indeed coming -- and Laffer is as good a prognosticator as we have -- then there's no reason not to profit from it.

Andy Obermueller does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.