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Making the best of low-interest savings

Greg McBrideSavers have been running on a treadmill toward higher interest rates -- as time passes, there is no real progress. The misery of investors has been cause for celebration for borrowers as interest rates remain historically low, with a cloud of uncertainty keeping them low.

The forecasts made by the economists at 24 of Wall Street's biggest bond dealers in January 2002 tell an important story. In developing forecasts for 2002, 21 of 24 said interest rates would first begin to rise sometime in 2002, which was the prevailing viewpoint at the time. Only three saw the Federal Open Market Committee not boosting rates until 2003, though none foresaw the half-point interest rate cut in November 2002 that brought rates to a 41-year low.

What this illustrates is the difficulty of forecasting in an ever-changing world, even for some of the best-educated and well-respected Wall Street professionals. Just as rates have remained lower, for longer, than anyone first envisioned, the opposite could very well be true when rates one day begin to climb.

Two weeks ago in this space, the prudent steps for borrowers -- debt consolidation and debt repayment -- were addressed.

So how can savers best make lemonade from the lemons of low interest rates?

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For those individuals dependent upon interest income, a laddered portfolio can and will afford greater protection from interest rate volatility as cash investments are diversified over a range of maturity dates. A laddered portfolio is one in which an investor buys a series of CDs with staggered maturity dates. Investors thus avoid rolling over their entire CD portfolios at a low point in the interest rate cycle. In low-yield environments such as today's, investors with laddered portfolios do better.

Take, for example, an investor with a portfolio of five-year CDs laddered to mature at annual intervals. Only 40 percent of this portfolio has been reinvested at sub-normal yield levels and, assuming no dramatic improvements for the remainder of 2003, by year-end 60 percent would have been reinvested. But even then, the other 40 percent would still be chugging along at much higher interest rates, including the portion invested in 2000 at what was then a five-year high.

Just as the laddered structure has provided protection in a time of continually declining interest rates, it would also benefit the investor in an environment of abnormally high interest rates by reinvesting at progressively higher rates. Don't think this will happen? Remember, no one foresaw the current state of interest rates as recently as 13 months ago.

What about those not dependent on interest income who have dutifully dispatched of high-interest debt such as credit cards, and refinanced the mortgage at rock-bottom interest rate levels? Consider using the extra cash to rebuild the safety net or emergency fund. Check out high-yield money market deposit accounts as a way to keep pace with inflation while preserving liquidity and having the protection of FDIC insurance.

The presence of this safety cushion provides greater flexibility for future investments or expenditures, but is a preventative to incurring debt at higher future interest rates should unforeseen circumstances arise.

Savers may be running on an interest rate treadmill, but certain actions now will help keep the finances in tip-top shape regardless of how flat or steep the grade of interest rates becomes.

Greg McBride is a financial analyst for Bankrate.com.

For advice regarding your specific situation, please e-mail one of Bankrate.com's Q&A experts or visit the Personal Finance Advice channel on Bankrate.com.

-- Posted: Feb. 14, 2003
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