The following is a guest blog post:
Over the last year, there has been quite a bit of chatter about the Fed and its intent to raise the interest rate. The current state of the economy seems to the catalyst for the change, but not everyone is convinced an interest rate increase is in their personal best interest.
Many consumers are worried that an interest rate hike could negatively impact their financial situation – a natural response to what the media makes out to be a fairly big move away from low, relatively affordable rates. But there’s good news mixed among the gloom and doom of the Fed’s decision.
Here’s what you need to know about an interest rate hike.
Long-term vs. Short-term Rates
All the banter about an interest rate increase boils down to the Federal Reserve Bank’s control over the federal funds rate – the cost at which banks and credit unions lend their reserve balances to other banks and credit unions on a short-term basis.
Keeping the federal funds rate low means financial institutions can borrow money for a minimal cost, and that savings is passed on to consumers in the form of low interest rates on lending products via the Prime rate. However, when the federal funds rate increases, it becomes costlier to borrow not only for banks and credit unions but you and I as well because the Prime rate also goes up.
Increasing the federal funds rate is typically done when the economy overall is growing steadily, and while that’s good news, a rate hike causes concern about how expensive it will become to fund some of life’s major expenses.
It’s important to understand that the federal funds rate has more of an impact on borrowing options that are closely tied to the Prime rate, meaning short-term interest rates are bumped up more than long-term rates charged on consumer lending products.
For instance, an increase in the federal funds rate hits personal finances more in the realm of auto loans, credit cards, and personal loans (lending vehicles with five or fewer years to repay in most cases) than home loans and student loans (lending vehicles with extended repayment terms over a decade or more).
Most folks in the market for a car loan or a short-term personal loan will feel the interest rate increase far more than those on the hunt for their next home, given that financial institutions are likely to pass on the higher expense of short-term borrowing directly to the consumer by increasing the Prime rate.
The increase in shorter-term lending costs may sound terrible for individual borrowers, but the Fed is unlikely to inflate the federal funds rate drastically over a short period of time. Instead, there is more likely to be a steady increase stretched out over the next few years, giving consumers in the market for either short-term or long-term borrowing less of a reason to panic.
Opportunities to Save
An interest rate hike by the Fed has its silver lining, too. Financial institutions are more apt to increase the interest rate applied to deposit accounts, including savings, money market deposits, and certificates of deposit. While the change may be minimal at first, over time, interest earned on deposit accounts can add up to a pretty penny. But there are reasons why we may not see that take place overnight.
Banks make their money off the difference between what they are able to charge for loans and credit cards in the form of interest rates and the rates they pay to savers for keeping their money held in an account. To maintain some degree of profitability, that spread has to be relatively high. So, while higher interest rates on plain-Jane savings accounts are on the horizon, it likely won’t take place at the same pace as increasing rates on lending products.
Restructuring Variable Debt
In the last decade or so, variable interest rates have become more of a common practice among banks, credit unions, and other lenders on products like credit cards and private student loans. Variable interest rates are just that – they fluctuate over time based on the Prime rate which is ultimately tied to the federal funds rate.
When the Prime has is low, variable interest rates on credit cards and loans are also low. The same is true when the rate goes up, and borrowers experience a higher total cost for any remaining balances on a loan or card. While consumers don’t have a choice to get out of the variable interest rate game when it comes to credit card debt, there is an opportunity to restructure student loan debt to avoid an interest rate bump.
Refinancing a student loan that currently has a variable interest rate may be a smart move for those who can qualify. There are several lenders in the private market that offer refinancing into a new loan that removes the worry of a variable interest rate by applying a fixed interest rate for the life of the loan.
With a fixed rate, the principal and interest payments on the loan are set from the start and do not increase or decrease over time. Borrowers will need to qualify, however, which may mean providing proof of steady income and a strong credit history. For those who have less than ideal credit or low income, utilizing a cosigner may be a possibility to secure a low, fixed rate.
Although the media makes it seem as though an interest rate hike is the end of affordable borrowing as we know it, the direct impacts to personal finances are not that dramatic. Getting a loan from a bank or credit union may cost more than it did a few years ago, but the change is eventually offset by an increase in rates applied to deposit accounts like savings and certificates of deposit.
Consumers with variable interest rate loans currently may be able to refinance into a still-low fixed interest rate loan, so long as the credit requirements are in place. Overall, an increase in the federal funds rate plays a role in personal finances, but it points to a strong economy moving forward.
Guest post by: Jacob runs his own personal finance blog over at Dollar Diligence. Through meticulously watching his money and extreme frugality, he was able to pay down over $25k in student loan debt in just 15 months. You can learn more about his story and follow him here.