With higher interest rates beginning to take hold, consumers should expect to pay more for car loans, credit card debt, and mortgages in the months ahead, but those who have an emergency fund set aside may also earn more at the bank.
Indeed, a rising interest rate environment impacts consumers differently depending on whether they are a borrower or a saver.
“When rates go up, there is a ripple effect that will likely lead to an interest rate increase on variable rate products,” said Bruce McClary in an interview, a spokesman for the National Foundation for Credit Counseling based in Washington, D.C. “In most cases, it is not a very large change, but even the most insignificant increases can have a major impact on budgets that are very tight.”
The Federal Reserve, the nation‘s central bank, increased its target federal funds interest rate Wednesday, continuing a series of rate hikes that started in December, 2015. And it signaled more rate hikes might be warranted in the coming year.
Higher interest rates signal confidence in the strength of the U.S. economy, as the Fed pulls back on its campaign to keep interest rates artificially low following the 2007-2008 financial crisis.
Lower interest rates stimulate economic growth by making it cheaper for businesses and consumers to borrow money to pay for things like office equipment and new cars. But low interest rates also may encourage overspending and unwise investment, leading to unproductive economic activity and inflation. The Fed uses its control of interest rates to try and strike a balance between achieving economic growth while keeping inflation at bay.
Interest rates trickle down
The federal funds rate, which is the rate banks charge each other for overnight lending, impacts consumers indirectly, but profoundly over time.
How? Commercial banks use it as a benchmark to set their own prime rate, which in turn dictates interest rates on most home equity loans and lines of credit, credit cards, auto loans and personal loans – even some small business loans.
A borrower who took out a 5-year personal loan for $25,000 at 4.5 percent interest would owe $466 monthly and pay a total of $2,965 in interest over the life of the loan. If that rate were 5.5 percent instead – 1 percent higher – that same borrower would owe $478 monthly, and pay $3,652 in total interest charges.
As such, rate hikes reduce the amount of discretionary income borrowers have for nonessential purchases, including vacations, restaurant meals, and luxury goods. It also impacts how much they can afford to spend on fixed expenses, which reverberates through the economy.
“As interest rates start to go up, it effects how much house people can afford, and therefore the price of homes will come down or stagnate,” said Neil Maxwell, a Certified Financial Planner™ professional with Maxwell Wealth Planning in Parker, Colorado, noting interest rate fluctuations help keep the economy healthy. “It is part of the cycle. Nothing lasts forever.”
The cost of new loans and variable rate debt would rise
It is important to note that rising rates only impact new borrowers and those with existing variable rate debt, such as adjustable rate mortgages, home equity lines of credit, and credit card balances.
If you already own a home with a fixed rate mortgage, have a fixed rate home equity loan, or have a federal student loan (most of which have fixed rates), interest rate fluctuations will not impact your monthly payment.
“Anybody who carries a credit card balance, and anybody considering applying for a new line of credit or mortgage loan should keep a close eye on where interest rates are headed,” said McClary. “It is always a good idea to assume things might change in one direction or the other and prepare for that.”
Existing homeowners with an adjustable rate mortgage, in particular, should ensure they are positioned financially to withstand higher monthly payments should interest rates continue to rise.
While some financial professionals suggest homeowners consider refinancing their ARM or higher interest fixed rate mortgage loan now, while rates remain low, McClary said there is no reason to rush in.
Mortgage rates are still hovering near historic lows and decisions related to long-term loans should never be dictated by interest rate movement alone, he said.
“There is no guarantee that rates are even going to rise and there is no set date on the calendar for when that might occur,” said McClary. “The main thing to think about is whether it makes sense for you to refinance given your financial picture.”
He adds: A refi only makes sense if you plan to stay in your house long enough to offset the closing costs involved – often referred to as the break- even point. Other factors include the rate you are currently paying, the impact on your monthly payment, and whether or not your credit score has changed since you locked in your loan, which would impact the interest rate banks would likely charge you for a new loan.
The same advice is true for those looking to purchase a new car, a home, or take out a personal loan, said Paul Golden, a spokesman for the nonprofit National Endowment for Financial Education in Denver, Colorado, in an interview.
While borrowing costs will likely rise as the Fed raises rates, that may not get passed along to consumers right away. Plus, rates historically only rise by a quarter-point or half-point at a time, giving borrowers ample time to manage their next move.
“Don’t get hung up on what interest rates are, especially if we are only talking about a quarter- or half-point hike,” said Golden, noting it is more important that consumers stay focused on keeping their debt-to-income ratio under control.
Ideally, he said, you want your housing costs, savings and monthly debt obligations to absorb about 30 percent each of your monthly income. The remaining 10 percent gives your budget a little wiggle room.
Credit card debt
Consumers who carry a credit card balance should be particularly wary going forward, as most variable rate cards are pegged to the prime rate and many charge rates of 18 percent or more.
The average credit card balance in American households is about $16,000, according to consumer web site NerdWallet.com.1 (Learn more: Credit card debt problems and fixes)
Be especially careful with retail cards offering zero percent teaser rates for the first 12 to 24 months. Borrowers who fail to repay their balance in full when the grace period ends may get hit with retroactive interest charges.
“It is true that a lot of people with variable rate credit cards could get into trouble if rates adjust upward and they cannot make substantial changes in other areas of their budget,” said McClary. “It is really a matter of planning ahead and looking at the terms of credit cards when accounts are opened. Think about what that might look like if rates rise and give yourself a financial range to operate within.”
A better savings yield — maybe
Higher interest rates are not all bad news, however.
Savers who park their emergency fund money in a bank or credit union, or purchase money market funds and Certificates of Deposit (CDs), may well see a nominal bump in their yield.
“The silver lining is that higher interest rates means more interest paid in savings, Certificates of Deposit and money markets,” said Golden. “If you have a CD now that rate is fixed until maturity, but if you are considering buying a new one maybe wait until the next interest rate hike to get the higher yield.”
With average savings accounts paying less than 1 percent, however, don’t expect a single interest rate hike (or three) to make you rich over night, he said. (Learn more: The value of a sound financial strategy)
Be aware, too, that banks may also not raise their yield on savings accounts immediately after a Federal Reserve rate hike, or at all, said Golden.
In a rising interest rate environment, consumers should consider the impact that higher rates may have on their existing loans, new debt they plan to incur and their personal savings. But they need, and should not, hit the panic button, said McClary.
“It always makes sense to look in front of you and not make decisions based on assumptions which are nearly impossible to predict,” said McClary. “It is far better to pay attention to your lifestyle, how you are using credit, and how much you are saving than to get too focused on which direction interest rates are heading.”
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This article was originally published in March, 2017. It has been updated.
1 Nerdwallet, “2017 American Household Credit Card Debt Study,” Dec. 11, 2017.
2 FDIC, Weekly National Rates and Rate Caps.