The Federal Reserve is meeting this week and is widely expected to raise its target rate by 25 basis points on Wednesday afternoon. While this could be good news for savers, it isn't such a good thing for people who owe money, especially on variable-rate products like credit cards. With that in mind, here's how a Federal Reserve rate hike could affect your bottom line.
How Federal Reserve rate hikes affect credit card interest rates
Increases in the Fed's short-term interest rate tend to have more of a direct impact on credit card interest rates, unlike other types of consumer debt, such as mortgages and auto loans. The vast majority of credit cards have variable interest rates, which have a direct connection to a benchmark interest rate. If your card's benchmark interest rate (which is usually directly connected to the Fed's short-term rate) rises, so will the APR you pay on purchases and cash advances.
What this could mean for you
It looks highly likely that a rate hike is going to happen. CME Group has the odds of a rate hike at 95.8% as of this writing, while Investing.com gives a lower (but still pretty high) 91.8% probability. So, it's fair to say that consumers should expect a rate hike, and it would be quite a surprise if we didn't get one.
As of this writing, the average credit card interest rate in the U.S. is 16.49%, according to Bankrate. So, a 25-basis-point increase would translate to an average credit card interest rate of 16.74%. According to analysis by WalletHub, this would cost American credit card customers an additional $1.5 billion in finance charges this year.
To get an idea of how this could affect you, let's say that you owe $10,000 in credit card debt at the national average interest rate of 16.49%. According to Credit.com's payoff calculator, based on a $238 monthly payment amount, you would pay off the debt in 64 months, and would end up paying $5,019 in interest. On the other hand, a quarter-point increase in your interest rate would result in $5,156 in interest based on the same monthly payment amount.
In other words, if you owe $10,000 at the national average interest rate, a Federal Reserve rate hike could translate to $137 in additional interest while you're paying off the debt.
Of course, this is a simplified example. It assumes you'll pay just the minimum amount each month (which the calculator assumes to be $238 for this particular amount of debt). If you accelerate your repayment, you could reduce the rate hike's impact. For example, if you pay $500 per month toward the debt, the increase in interest would be reduced to just $33.
This calculation method also assumes no further interest rate hikes, but it's important to be aware that experts are predicting a handful of rate hikes over the next few years.
One rate hike equals a small effect on your wallet
The bottom line is that a single Federal Reserve interest rate hike would likely have a small effect on your credit card debt. The amount of interest you would pay over a longer time period, such as by making the minimum payments, would increase slightly. On the other hand, if you pay significantly more than the minimum each month, you'd barely feel the effects of a 0.25% interest rate increase.
However, if the Fed continues to raise rates over the next several years, an increase in your credit card interest rate by 1%, 2%, or more could start to have a more noticeable effect on your cost of borrowing money.