Everyone seems ecstatic at the gains they've seen from the rally over the past year. But just as night follows day, higher interest rates almost always result from an improving economy. If you're not prepared for the impact that higher rates could have on your finances, you could be in for a huge shock.

How rates affect you
Interest rates have a big impact on your financial life. Both borrowers and investors have to deal with the implications of moving interest rates all the time -- and successfully navigating changes in prevailing rates can make a huge difference in your financial success.

Throughout the financial crisis, interest rates have stayed at historically low levels. For people dealing with their personal finances, low rates have done two important things:

  • For borrowers, low rates have made it cheaper to finance their debt. In particular, many homeowners have managed to refinance their mortgages at substantial savings, and those with adjustable-rate mortgages have thus far avoided the pain that would come from higher monthly payments that come when rates rise.
  • For savers who rely on the income their savings generate, however, low rates have created big difficulties. Plummeting rates on safe investments like bank CDs and Treasury bonds have pushed many people into riskier income-producing assets that have higher payouts, but also have more potential for loss in a rising-rate environment.

Moving in the wrong direction
If you've primed your portfolio for low rates, the improving economy may actually be bad news. As economic conditions get better, more business activity means increased demand for capital. That higher demand forces rates to rise. In addition, the federal government is tapping the bond markets for unprecedented levels of borrowing, which should also push rates up over time.

You might think that higher rates would be good news for investors, because it means that investments produce more income. The problem, though, is that if you already own existing low-rate assets, increasing rates pushes the value of those assets down. So all the investors who've put billions of dollars into the bond market over the past year could face potential losses of principal, with the biggest drops facing those who chased higher yields from more volatile long-term bonds.

Stocks aren't immune
If you think that interest rates only affect fixed-income investments, you couldn't be more wrong. Especially within certain industries, interest rates play a vital role in profitability and revenue.

Take financial stocks, for instance. Currently, there's a fairly wide spread between short-term and long-term rates. Short-term Treasury bills pay less than 0.25%, while 30-year bonds have fetched yields between 4.5% and 4.75% lately. Because most banks obtain capital from their customers via short-term deposits, they don't have to pay much in interest in a low-rate environment. Meanwhile, they can lend that money out at higher long-term rates. As long as that gap persists, it can generate big profits. Take a look, for example, at the net interest income that major banks have earned in the past year:


Net Interest Income, Last 12 Months

Citigroup (NYSE: C)

$48.9 billion

Bank of America (NYSE: BAC)

$47.1 billion

JPMorgan Chase (NYSE: JPM)

$51.2 billion

Wells Fargo (NYSE: WFC)

$46.3 billion

US Bancorp (NYSE: USB)

$8.5 billion

Source: Capital IQ, a division of Standard and Poor's.

Rates can also have a big impact on other stocks. Cash-rich companies like Cisco Systems (Nasdaq: CSCO) and Google (Nasdaq: GOOG) are earning next to nothing on their multibillion-dollar cash hoards now, but even if short-term rates were to rise to 3% or so, the resulting income could have a material impact on earnings. For instance, with Google, $24.4 billion in cash in investments at 3% would produce more than $730 million in income, boosting its net income by more than 11%. Conversely, debt-laden companies that rely on low rates to refinance borrowings regularly could find themselves out in the cold.

Do the right thing
The key to dealing with rising rates is to make the most of it both with your borrowing and your investing. With your debt, that means locking in low rates now if you can. Among your investments, it means the opposite: Stay flexible to take advantage of rising rates as soon as they come. And finally, it means paying attention to your stocks to make sure they're well-positioned to benefit from higher rates in the future.

An improving economy is good news for everyone, but it will likely come at the price of higher rates. As long as you take steps now, you'll be ready when they finally come -- and a little foresight could prevent big losses down the road.

Great returns don't have to stop now. Find out from Fool contributor Tim Hanson how you can make more money in 2010.