According to U.S. Federal Reserve Chairman Jerome Powell:
“Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy --- that is, neither speeding up nor slowing down growth."
But what happens when they take a hike? Here's how rising interest rates can directly impact your personal finances.
The most obvious impact is the higher cost to borrow money. Rate hikes may also lead to higher interest charges on debt you already owe.
When the Federal Reserve increases the federal funds rate, banks typically pass that increase on to consumers. (This is the rate it charges banks on short-term loans.)
Keep in mind that increases in the federal funds rate are usually gradual. Interest rates rarely jump several percentage points at once, or even in a short period. That means the impact on your personal finances will be gradual as well.
Movement in interest rates will only impact your current debt if you pay variable interest. Fixed interest rate loans, such as student and mortgage loans, are not impacted by rate increases.
If you’re repaying student loans, you probably will not see much impact --- if any --- due to higher rates.
Federal student loans taken out since 2006 have fixed interest rates, which means they're not subject to change under a rate hike.
However, federal student and private student loans acquired before 2006 may have variable interest rates. Even so, minor changes in the federal funds rates will not dramatically affect your student loan interest. Still, you may want to consolidate or refinance private and federal student loan debt into a fixed loan.
Home and car loans
One common misconception is that the Federal Reserve sets mortgage rates. Rather, the Federal Reserve sets the federal funds rate. This may influence the movement of mortgage rates --- especially adjustable rate mortgages (ARMs). But they are not directly related. Mortgage rates have been on a steady increase since the end of 2017 due to other economic factors.
If you’re planning to buy a car in the near future, an interest hike may lead to higher borrowing costs. It all depends on when you buy and who finances your loan.One way to avoid the impact of rising bank rates to capitalize on financing incentives. Manufactures love using these to drive sales.
If you finance your car through a bank, the increase in federal funds rates will trickle down to higher auto loan rates. However, the impact on your monthly payment should be minor. For example, purchasing a $40,000 car at 5 percent interest for 48 months leaves you with a monthly payment of $921. At 6 percent, the payment increases by only $18, to $939.
Where you may notice the impact of rising interest rates the most is your credit card debt. Credit card rates are variable, and tied to the prime rate --- the baseline banks charge. (Typically, it's a few percentage points higher than the federal funds rate.)
When the federal funds rate increases, so does the prime rate. That, in turn, leads to higher rates for variable credit card interest. Because of this:
- Your interest charges will accumulate faster.
- The minimum monthly payment you owe will be higher.
When rates hike, here are some best practices to consider:
- Avoid adding charges to your balance.
- Review debt consolidation options.
- Consider moving current balances to a credit card with a zero percent introductory offer. (This will allow you to pay down debt with no interest charges for a few months.)
One potential benefit of a rate hike is you may earn more interest on your:
- Checking accounts.
- Savings accounts.
- Certificates of deposit (CDs).
Like interest on debt, the actual impact of gradually higher rates on savings will be minimal. Banks are also slower to raise rates paid on savings products than they are on debt financing. (Hmmm, I wonder why?)
Meanwhile, bond investors should expect to lose some money. Rising interest rates cause bond prices to fall. That's because bonds are less valuable if higher-rate bonds become available. Now, you will continue to receive money from your bond funds. But when you sell the fund, you will likely get back less than what you paid for it.
For investors in individual bonds, the impact depends on two courses of action:
- If you hold to maturity, individuals bonds will continue to pay the same interest. No matter where interest rates are at maturity, the issuer will pay back your original investment.
- If you sell before maturity, it will be for less than what you paid due the decrease in value from the rate hike.
Although interest rates have been on the rise in 2018, they are still rathyouer low by historical standards. Still, it's important to understand how a major hike will impact:
- How you repay loans.
- How you handle credit card debt.
- How you manage savings and investments.
By keeping these three factors in mind and a healthy pulse on the market, you should be able to limit the negative impact rising interest rates have on your personal finances.
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Joel Palmer is a writer and personal finance expert who focuses on the mortgage, insurance, financial services, and technology industries. He spent the first 10 years of his career as a business and financial reporter.