With multiple rate hikes in the past twelve months, many people are asking important questions about interest rates. What’s the effect of higher interest rates on the economy and what does it mean for individuals? Read on for a run-down on rate hikes: why they happen, what they mean, and how they might affect you, your family and your finances.
Why Do Rate Hikes Happen?
The Federal Reserve Board, colloquially known as “the Fed”, is responsible for setting the federal funds rate. Banks use this interest rate to adjust their own rates on loans, credit cards, savings accounts and other financial products.
In general, the Fed raises rates when the economy is doing well. This helps to slow down growth and prevent inflation. When the economy is sluggish, the Fed might lower rates, in order to encourage the spending and borrowing that can lead to wider-scale economic growth.
This year, with inflation on the rise, the Fed has hiked interest rates multiple times in an attempt to slow down rising prices. On the other hand, rates were cut to nearly zero in 2020 directly after the start of the COVID-19 pandemic, in an attempt to encourage spending and support the economy in uncertain times.
The Fed has an opportunity to adjust interest rates eight times per year, following regular meetings of the Federal Open Market Committee. No rate will last forever, but even short-term rate changes can impact consumers in big and small ways.
If You’re a Homeowner…
Homeowners or soon-to-be homebuyers can see a sizeable impact when the Fed raises interest rates. If you’re looking to purchase a home, be aware that taking out a fixed-rate mortgage at this time may leave you with a higher interest rate for many years to come. This is why, following a rate hike, some home loan borrowers may choose to delay their purchase or opt for a smaller mortgage.
If you’re committed to buying a home before interest rates fall, the good news is that you can always refinance your loan in the future to take advantage of a lower interest rate. You might also choose to borrow with an adjustable rate mortgage (ARM). ARMs can offer a lower initial rate for a set period of time, after which your interest rate will change depending on the Fed.
People who already own a home and are currently paying off a mortgage will likely see no effect from a Fed rate hike. This is because the interest rate you get at the start with a fixed-rate mortgage is the interest rate you have for the life of the loan, unless you decide to refinance. However, if your original loan was an adjustable rate mortgage, and if the initial set-rate period is through, you should expect to see a higher monthly payment due to increased interest rates.
If You’re a Loan Borrower…
If you are paying off student loans, car loans or another kind of personal loan, expect a similar impact to homeowners. Variable rate loans will likely require increased payments in times when the Fed hikes rates, but if your loan is fixed-rate, you shouldn’t see much change. For borrowers looking to take out a new loan, be aware that higher interest rates at the moment may mean a higher cost across the life of the loan.
If You Have Investments…
While a rate hike from the Fed doesn’t directly impact the stock market, the indirect effects can be significant. Rising interest rates signal reduced consumer spending and a more pressurized time for doing business—generally leading to caution across the equities market.
If you own stocks, you may see a decline in the worth of your portfolio after an interest rate hike, but keep in mind that rate fluctuations are a normal part of economic growth. A balanced, long-term investment portfolio shouldn’t not see lasting effects from a rate hike, but if you’re concerned about the recent movement of stocks in an investment or retirement account, get in touch with a professional financial advisor.
Bonds, unlike stocks, typically offer a stronger prospect for investors when interest rates rise. Higher interest rates mean falling prices on bonds, so if you’ve been considering a low-risk, fixed income bond, it might be a good time to investigate options.
If You Have a Savings Account…
Credit unions and banks set their Annual Deposit Yields (APYs) based on the Fed’s rate, so a rate hike is usually good news for anyone with an interest-bearing savings account. If you’re not sure what APY rate you’re currently receiving—check! Understanding your APY will help you to choose the best vehicle for your liquid savings.
If You Have a Credit Card…
Again, financial institutions rely on the Fed to determine Annual Percentage Rates (APRs) for credit cards. Nearly all credit cards have an adjustable rate, which means your interest owed can change at any time—and a higher rate from the Fed will mean higher interest charged to you on late or missing payments. To avoid needing to pay more interest, aim to pay off your entire credit card balance on time, whenever possible.
On the other hand, many credit cards offer a 0% APR introductory period. This period isn’t affected by the Fed’s rate, so you don’t need to worry about a sudden pile-on of interest payments. However, when the introductory period ends, you will need to start paying interest on outstanding balances. Again, paying off as much of your balance as possible will help to reduce the financial impact of changes from the Fed.