Last Wednesday, June 14th, the U.S. Federal Reserve Bank (the Fed) raised the interest rate for the fourth time since 2015. The quarter percentage point increase brought the target federal lending rate to a range of 1%-1.25%.
It is fair to hear that and ask, “so what?”
What do you mean the Fed raised the interest rate?
Think about when you get a loan to buy a house. You ask the bank for a specific amount of money and the bank says they can lend it to you at an interest rate of X%.
The bank doesn’t necessarily have all that money in the safe, so they borrow it from other banks. They borrow at the Federal Fund Rate, otherwise known as the federal lending interest rate. When the federal rate increases, that increases the borrowing costs of the banks, which can have pass through effects to the end consumer.
Think of it this way: the seeds that the Farmer needs to plant cost a bit more this year, so the Farmer raises the price of their produce at the market to support their margin.
But just how much can that affect you? The impact varies by loan type, and it may not be as much as you think.
- Credit Cards: A credit card’s interest rate is tied directly to the Fed’s benchmark rate, meaning the rate on your card will rise and fall with it. If you have debt, you will be affected. If you do not, then you will see no effect.
- Long-term fixed-rate: These rates are not tied to the Fed’s rate, so you won’t see much impact from this move. Also, if you already have a fixed-rate mortgage, you won’t be affected. Your rate is fixed.
- Adjustable Rate Mortgage (ARM): You’re safe if you’re in the beginning of your ARM. After that, if rates are rising it is likely that you would see your monthly payment increase.
- Home Equity Line of Credit (HELOC): These are tied directly to the Fed’s rate. Your interest rate will rise and fall with it.
- Auto Loans: If you are shopping for a car, you’d see an increase in the interest rates, however the impact is minimal ($3/mo on a $25,000 loan). Better option: pay cash for a car and avoid an auto loan
- Savings Rate: Unfortunately, you won’t see an increase here. Banks can be slow to pass these margins on to consumers, so you’re better off stashing your money in higher-rate online saving accounts (short term/emergency fund) or low-cost index funds (long term)
The impacts of raising the Federal Fund Rate
A majority of credit cards these days have a variable interest rate, which means they are a direct connection to the Fed’s benchmark rate. Therefore, a quarter percent increase means those carrying balances on their cards will pay an extra $2.50 per year in interest for every $1,000 of debt.
But, but, but
You’re financially savvy enough to not be carrying any credit card debt, right? If you are, focus on paying this down as quickly as possible. Credit cards have some of the highest interest rates out there, so any debt can be crushing.
Long-term fixed-rate mortgage
Long-term fixed mortgages rates are generally tied to yields on 10-year US Treasury notes, and not singularly specific to the federal interest rate like credit cards are. In fact, long-term fixed mortgages rates are typically influenced by a combination of the economy, the federal interest rates, and inflation.
Because of this, the rates began to rise even before the Fed made any moves. According to bankrate.com, the average 30-year fixed-rate mortgage is 4.02%. That is up slightly from the record low of 3.36% in December of 2012.
Moral of the story? Long-term fixed-rate mortgages aren’t affected all that much by the rate hike.
I should also note: if you already have a fixed rate mortgage, your rate will be unaffected. Your rate is fixed, it will not change. This only impacts those who are shopping for a mortgage.
Adjustable Rate Mortgage
That can’t be said for Adjustable Rate Mortgages, otherwise known as an ARM. With an ARM, your interest rate is locked in for a set period of time at the beginning of the mortgage, but once that time period ends, the rate can adjust each year depending on what interest rates are doing. If rates are going up, so will yours, increasing your monthly payment.
Home Equity Line of Credit
A Home Equity Line of Credit (HELOC, pronounced He-Lock) is another mortgage related item that should be mentioned.
Since HELOCs are tied directly to the prime rate (which is another fancy way of saying the interest rate), any increase in the Fed rate will increase payments on a HELOC. It’s similar to a credit card in that way. For example, the quarter percent increase would increase monthly payments on a $50,000 HELOC by $10 to $11.
A quarter percentage point change on a $25,000 car is equal to $5 more per month. Not enough to dissuade someone from buying that car.
Do you need a $25,000 car though? Unlikely.
Instead of taking out a loan to buy a vehicle, consider looking at a model a few years older and see if you can pay in cash. If cash won’t cover all of it, at least make as big a down payment as possible to limit your debt exposure.
Auto loan summary: Auto loans are fixed, so if you have one, you’ll see no change. If you’re shopping for one, you won’t notice the difference.
If you were hoping that rate increases would also translate to increases in bank savings rates, I am sorry to inform you that is not the case.
Savings rates are incredibly low right now, and don’t do much for you money besides provide some peace of mind. The average savings account rate is 0.08%. That isn’t going to dramatically increase any time soon.
If you are stashing some money away in a savings account (like creating an emergency fund), I’d recommend searching around for online banks. They offer savings rates up to 1.0% to 1.2%. That isn’t a lot – $10 on $1,000 in the bank – but it’s still better than nothing.
Better options for your extra cash? Invest in low-cost index funds. Yes, you are taking more risk, but if this is money you don’t mind stashing for the long-term (10+ years), this is the place to put it.