Guest Post: By Patty Moore, a blogger who writes about personal finance, careers, and family. You can follow Patty on Twitter @WorkMomLife.
In the United States, interest rates are controlled by the Federal Reserve Bank. It controls a key interest rate, the Fed Funds Rate, that banks charge each other to borrow money. Changes to the Fed Funds Rate ripple through the economy and can directly affect your finances. That’s why so much attention is paid to forecasting any upcoming changes to the Fed Funds Rate.
The Federal Reserve meets six times a year to consider the Fed Funds Rate, and the next meeting is in December. At the most recent meeting, in September, the Fed indicated that it will raise the Fed Funds Rate by one-quarter of 1 percent in December. It bases these decisions on various economic conditions. One is inflation – the general rise in prices across the economy. The Fed fights high inflation, and raising interest rates is an important tool. Note that the Fed anticipates inflation before it actually occurs to get an early jump on the fight against it.
Inflation and Interest
Inflation occurs when the economy overheats and shortages in materials and/or workers develop. Shortages force companies to bid up the amount they’ll pay to workers and suppliers in order to compete with each other. These increases show up in the prices of things you buy, and also in your take-home pay.
Raising interest rates will slow down inflation, because borrowers have to pay more interest when they borrow. That leaves less money left over to pay higher, inflated prices and therefore slows down the economy, which slows down inflation.
So, when the Federal Reserve see signs that the economy is threatening to overheat and raise the inflation rate, it boosts the Federal Funds Rate to slow everything down.
Impact on Borrowers
As we said, a change in the Fed Funds Rate ripples through the economy, because lenders have to pay more interest on the money they borrow in order to lend it out. Therefore, rates will increase on new credit cards, mortgages, car loans, personal loans. If you have borrowed money at a variable interest rate – that is, at a rate that can change over time – then you can expect to pay more interest charges. Most credit cards are variable rate, so a higher Fed Funds Rate should show up shortly on your credit cards’ monthly billing statements. More of your hard-earned money must then go to paying interest on any unpaid balances. You can avoid this effect by paying off your entire balance each month, but that’s often not possible for many of us.
Existing fixed-rate loans, such as those on cars and most mortgages, aren’t affected by changes to the Fed Funds Rate, but new ones will be issued at higher rates. Existing credit cards and adjustable-rate mortgages can see rates change shortly after a Fed rate hike. You can deflect changing interest rates by refinancing variable rate debt (ex. Credit cards) into fixed rate products, see example here. Some experts suggest moving variable rate credit card debt to a fixed rate term loan during rising interest rate environments.
Private student loans frequently charge a variable interest rate. Depending on your student loan agreement, you might see a higher interest rate on your loan right away, or you might not see it for up to a year. Eventually, the higher rate takes hold and your remaining private student loan debt will cost you more money each month. Most student loans in America are made by the federal government and have a fixed interest rate that protects you from rate hikes. However, the Department of Education sets new interest rates each spring that take effect on July 1, causing new loans to be more expensive during inflationary times.
If you have any adjustable rate loans or credit cards, try to replace them with fixed-interest-rate ones when rates are rising. Also, try to pay off your credit cards in full each month, so that you don’t have to pay any interest at all on credit card balances.
Impact on Savers
The flip side of interest rate hikes is that savers earn more interest on their savings. Fed Fund Rate hikes might not impact the amount of interest you earn right away, because banks and other savings institutions use a “sticky” interest strategy. This means that the banks raise interest money on loans right away, but take their time passing along higher interest rates to savers. That’s unfair, but it’s also a fact of life. Eventually, competition causes banks to pay more interest on savings accounts, certificates of deposit and money-market accounts. Investors who buy Treasury bills see interest rates rise quickly on new debt in response to Fed Funds Rate hikes.
Naturally, the effects of a lower Fed Funds Rates are the opposite – good for borrowers, bad for savers. When interest rates are very low, as they had been from 2009 to 2016, it’s hard for some retirees to earn enough interest on relatively safe savings accounts and might turn to riskier sources of income, such as stocks and junk bonds. That’s unfortunate, because retirees are the least able to absorb losses, since they are no longer earning a salary or wages.
- The Federal Reserve is increasing interest rates in 2018.
- If you currently have variable rate debt (ex. credit cards), plan on your interest rate and monthly payment increasing in 2018. Let this be motivation to pay down debt!
- Fixed interest rate debt will not be impacted. Consider refinancing variable rate debt to a fixed interest rate.
- The interest rate you receive on your savings accounts, CD’s, and money-market accounts will increase! This is good news for savers!
About The Author
Patty Moore is a single mother to one beautiful daughter while working 40 hours a week. She writes about parenting, family finances, and creating a work life balance in her blog Working Mother Life. Her hope is to help other women in similar situations to hers become better and more balanced mothers.