Author: Jordan Wathen | July 17, 2018
How might additional rate increases affect you?
After increasing the benchmark interest rate twice in 2018, the Federal Reserve telegraphed its intention to raise interest rates twice more this year. If the Fed follows through, it will deliver four full quarter-point rate increases this year, bringing the federal funds rate up to 2.5% from the current level of 2.0%.
Rate increases affect more than just the rate at which banks lend to one another overnight. The benchmark rate ultimately affects the entire financial system, from banks to insurance companies. Let’s look at the six ways the Federal Reserve can impact your wallet by increasing or decreasing the overnight interest rate.
1. Get ready for higher rates on savings accounts
As the Federal Reserve increases interest rates, banks may feel compelled to pay a higher interest rate on your savings and checking accounts. Many regional and online banks are now paying close to 2% on cash kept in a savings account, while others are paying 3% or more on five-year certificates of deposit. As interest rates rise, the most competitive banks will increase the interest rates they pay to savers every time the Fed acts.
Of course, whether or not your personal bank will increase your interest rate depends on how hungry it is for deposits. One of the best indicators that a bank may choose to increase the rate it pays for deposits is its loan-to-deposit ratio, which divides its loans outstanding by the deposits its customers entrust with the institution. The higher the ratio, the more likely a bank will have to compete for deposits by increasing rates paid to its customers.
2. Your credit card debt will become more costly
While the Federal Reserve increases rates by increasing the federal funds rate, the increases affect other lending benchmarks, such as the prime rate, too. In the last three years, the prime rate has increased by 1.5 percentage points, while the effective federal funds rate increased by about 1.6 percentage points. The relationship between the prime rate and the effective federal funds rate can be a big deal for credit card users, particularly those who carry a balance.
If you look carefully at the terms and conditions of your credit card, you’ll likely find that the rate charged on your balance is calculated by adding a premium on top of the prime rate. Thus if your card charged an APR equal to Prime plus 10.5%, it would currently carry an APR of 15.25%, based on the current prime rate of 4.75%. That’s roughly in line with the last reported national average of 15.3%. Of course, if you pay your balance in full every month, as you should, the rate you pay on your credit card is irrelevant. Credit cards only charge interest when you carry a balance from month to month.
3. Auto buyers should expect higher APRs
One thing you should know about the Federal funds rate is that it is a super short-term (overnight) interest rate. Thus, when the Federal Reserve votes to increase interest rates, it has the greatest impact on short-term loans such as car loans, which are typically paid off over the course of 48 to 72 months.
Data from the Federal Reserve shows that the finance rate on 60-month auto loans has increased from 4.05% in November 2017 to 4.75% in February 2018, driven in part by the Fed’s decision to raise the benchmark rate. The good news, though, is that many auto manufacturers still offer 0% APRs to buyers with excellent credit. Plus, higher rates have a much smaller impact on affordability for short-term loans like car loans than they do to longer-term loans like mortgages. The difference between paying 4% or 5% interest on a five-year, $30,000 auto loan amounts to only $14 a month, which is a rounding error on a payment in excess of $500 per month.
4. Your insurance premiums could fall
It’s smart to shop around for auto or homeowners insurance frequently to get the lowest premiums, advice that is especially true in a rising-rate environment. Because insurance is prepaid (premiums are paid before coverage kicks in) insurers are able to invest the money and earn a small amount of interest due to the lag in when they receive cash from customers and when they pay out cash for claims.
The insurance industry is extremely competitive, and insurers price insurance policies partly based on how much they can earn investing the premiums they take in from every contract. When rates are high, insurance companies can afford to charge less for the same coverage, since they anticipate making more money by investing the premiums for short periods of time. Of course, you shouldn’t expect that your car insurer will lower your rate just because interest rates are rising. Shop around, and if you find a lower quote, ask your existing insurer to match the premium, or be prepared to change companies all together.
5. College financing costs rise
Current undergraduate students will see a higher interest rate on government student loans for the 2018 and 2019 school year. In the upcoming year, interest rates will rise to 5.05%, up from 4.45% during the 2017 to 2018 school year. Luckily, Stafford loans for school carry a fixed interest rate, so the rate increase only affects new borrowings, not existing loans.
Rates for federal student loans are set by Congress. The rate is based on how much it costs the government to borrow money for a 10-year term. Thus, when rates on the 10-year U.S. Treasury note increase, so do rates on government student loans. As the Fed has increased short-term interest rates, investors are demanding a higher rate from longer-term U.S. government notes, and federal student loan rates are rising in response.
6. Your mortgage payment may swell
Homeowners who have variable rate mortgages are likely to see their monthly mortgage payments increase with each increase in the Federal funds rate. That’s because variable rate mortgages are typically based on a short-term interest benchmark, such as the Prime rate or LIBOR. Both the Prime rate and LIBOR increase almost 1-for-1 when the Federal Reserve decides to increase interest rates, affecting anyone who has an adjustable-rate mortgage.
Luckily, people who have a fixed-rate mortgage won’t see their interest rates increase, and new homebuyers may just find that higher overnight rates have little impact on long-term 30-year fixed mortgages. Note that while the Federal funds rate increased by about 1.6 percentage points since the fall of 2015, rates on 30-year mortgages have increased only about 0.7 percentage points. That’s because mortgage rates are influenced more by long-term interest rates and the demand for mortgage-backed securities (packages of mortgages that are sold to investors). Fixed mortgage rates are affected indirectly by Fed policy.
Why the Federal Reserve wants rates to move higher
Interest rates are one of the primary levers for the Federal Reserve to manage the economy. The Federal Reserve is faced with a delicate balancing act of setting interest rates at a level that promotes economic growth without causing high inflation in the cost of goods and services. The Federal Reserve has a long established policy of trying to target an inflation rate of about 2% per year.
Many experts partially blame the Fed for the tech stock bubble of the late 1990s and the real estate bubble of the 2000s, believing that keeping rates too low for too long fueled speculative investment bubbles that ultimately burst. On the opposite end of the spectrum, former Federal Reserve chairman Ben Bernanke often talked about how the Federal Reserve was partly responsible for the longevity of the Great Depression because it was too tight with monetary policy, and should have injected more liquidity into the banking system to drive down rates even further.
The Fed doesn’t have an easy job to do. But for those of us who aren’t setting policy, it’s important that we all understand how the Fed’s interest rate decisions play through in our personal finances.
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