As of July 27, the U.S. national debt stood at $32.66 trillion, an increase of more than $1.4 trillion just since June 1. When Congress suspended the debt ceiling in June, it allowed existing budgeted spending to take place.
At the same time, as part of the fight to get a budget passed, it also instituted "extraordinary measures" to allow other uses of money meant for federal employees' benefit funds. But this move, which involves money the government essentially owes to itself, eventually has to be repaid. The government borrowed from Peter to pay Paul -- and Peter needs to get his money back.
This combination led to a massive increase in debt in just under two months. On top of the direct spending impact driving the higher debt, the current higher interest rates translate to higher debt-servicing costs, which also adds pressure to overall debt and deficit levels.
As worrisome as that is, the reality is that, as an ordinary citizen, you can't control the national debt and its related consequences. But you can control what you do in response to the situation.
After all, the spillover effect from higher interest rates, as borrowers need to offer more to attract those willing and able to lend money, can cause problems for the rest of us.
Here are the things you can -- and should -- take control of.
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First: Get your current debt under control
If you have any debt, make sure you understand whether that debt is at a fixed interest rate or a variable interest rate. If it's a fixed rate, your interest cost as a percentage of your balance won't change as long as the debt is active.
But if it's a variable rate, then that cost will change as interest rates do. For instance, many mortgages are variable-rate loans, and those that are, typically have an adjustment period that determines how frequently that rate changes.
Rising rates mean that the cost of your existing variable-rate loans will go up when those rate adjustments happen. It also means that any new debts you take out will likely be at higher rates than they would have been before. This makes it crucially important to get your debts under control now.
The most effective way to do that is with something known as the debt avalanche method. Essentially, you line up your debts from highest interest rate to lowest interest rate. On all debts except the one with the highest interest rate, you pay the minimum. On your highest-rate debt, you throw every dime you can above and beyond that minimum toward paying off that debt.
Once it's paid off, you put all that money you had been paying toward that debt to eliminate what is now your highest-rate debt of those that remain. Repeat that process until most, if not all, of your debts are paid off.
Each time you pay off a debt, you free up the cash (the principal and the interest) that you had been paying toward it. That gives you tremendous breathing room to handle the higher costs associated with higher interest rates on any remaining debts.
As for debts you might be willing to keep, they should have three key properties:
- A low interest rate: Mid-single digits or below. If you don't see a decent path to potentially outperforming your debt from your investments, it's not worth keeping that debt around.
- A low payment: Low enough so that you can easily cover it from your income while still having enough left over for your other life priorities.
- A clear purpose for your future: The reality is that debt payback has a guaranteed return while investing offers a potential. If you don't have a clear purpose for debts you have, it becomes harder to make rational decisions with the money you have invested when (not if) the market moves against you.
Next: Understand how debt and interest rates affect investments
Once your personal debt is under control, you can shift your attention to your current and potential investments. The reality, as 2022 showed us, is that higher interest rates are often associated with lower stock prices. There are two key reasons for this.
First, investors typically have limited funds available to invest. The higher interest rates are, the more an investor is willing to own interest-bearing debt, which lowers the money that person has available to invest in stocks. When you aggregate decisions like that across the entire population of investors, that's a key driver behind why stock prices drop when rates go up.
Second, the more expensive debt gets, the less debt that companies are willing to take on. This is because for debt to make sense for a company, it needs to be able to take the money it gets from that borrowing and put it toward projects that it thinks will have a higher rate of return than the debt costs. The higher interest rates are, the harder it gets for an investment to clear that hurdle, which leads to less new investment in growth.
The less a company invests in its growth, the harder it is for it to grow. And the lower a company's growth prospects, the less of a premium that investors are willing to pay for its stock, which can also lead to lower stock prices.
Finally, look for bargains
If there's an upside to the challenges caused by heavy debts and higher interest rates, it's that the natural tendencies for stocks to drop due to those conditions can often lead to stock market bargains. Value investing is a strategy that looks to buy companies whose shares are priced below what a rational investor would pay for the company, based entirely on its future cash-generating abilities.
When interest rates were low and stock prices were high, it was hard to find bargain stocks in the market. Now that higher debt levels and higher interest rates have affected many stocks, many more opportunities are becoming available. For well-prepared, value-oriented investors, now looks like a tremendous time to go bargain-hunting.
Get started now
Of course, getting your own financial house in order is that crucially important first step in adjusting to the new reality driven by the debt ceiling situation. With rates higher than they've been, the sooner you get started, the better your chances are of keeping your debts under control.
That gives you the best shot of ultimately taking advantage of what the market is offering today. So make today the day you take that crucial first step for yourself.
