The cost to borrow money is getting very expensive. In an effort to reduce inflation, on July 27th, the Federal Open Market Committee (FOMC) raised the federal funds rate for the fourth time this year. Just like the previous interest rate hike on June 15th, this increase was also 0.75 percentage points or 75 basis points.
In making the announcement, the Federal Reserve Chairman, Jerome Powell, said the Fed’s benchmark interest rate is now at a level that’s believed to neither stimulate nor restrain growth, which could see rate hikes slow in the coming months. The FOMC is due to meet again on September 20-21, 2022.
If you have credit card debt or plan to obtain financing to buy a car or home loan this year, you probably have questions about how the Fed interest rate increases will affect your savings, loans and financial plans.
How the federal funds rate impacts consumer interest rates
When the Federal Reserve increases or decreases the federal funds rate, which is the average interest rate financial institutions pay for borrowing money, interest rates on the money consumers borrow on credit cards, auto loans, and other short-term loans are also impacted. The Federal Reserve adjusts the funds rate depending on economic conditions, such as to slow inflation, which was the reasoning behind the June rate increase.
As the Federal Reserve anticipates additional interest rate hikes, knowing how your financial situation will be impacted as interest rates increase and how best to manage your finances during this time of uncertainty is essential.
Increased credit card interest rates
When the federal funds rate increases, many banks and financial institutions increase their prime rate, which is the interest rate they offer consumers with good credit. Once the prime rate increases, variable rates follow shortly after, resulting in more costly annual percentage rates (APRs) and minimum monthly payments for cardholders. The most recent Fed rate hike was 0.75%, which means you will likely see an increase of at least 0.75% on your credit card interest. For example, if your current interest rate was 16.24%, it will likely increase to 16.99% over the next one or two billing cycles.
Advice: Focus on paying down your credit card debt
If you currently hold any credit card debt, you should expect to see your APR and monthly minimum payments rise, making it challenging for many people to reduce their outstanding credit card balances.
In response to the FOIMC announcement on July 27, 2022, Michele Raneri, vice president of U.S. research and consulting at TransUnion, said credit card holders will see slighly higher monthly payments. “With the average consumer credit card balance of about $5,200, today’s interest rate hike for consumers who do not pay off their balances in full will raise minimum monthly payments by less than $4, or about $40 per year.”
Here are a few ways to reduce your credit card debt:
- Try using the Avalanche Method for reducing debt by paying off the debt with the highest interest first and working your way down.
- Re-evaluate your budget to see if you can save more to reduce your credit card debt faster.
- Pay at least the minimum credit card payment on time each month to avoid incurring late fees in addition to interest.
- Avoid using your credit cards for regular expenses other than emergencies while interest is high.
- Research balance transfer cards with a lower interest rate than the card you currently hold. Look for cards with a low or 0% introductory rate for 12 months if you have great credit.
Higher returns on savings accounts
While high interest rates are not welcome news for borrowers, a rate hike can benefit savers. Higher interest rates mean higher yields on your savings account. When you set up a savings account with a bank, you are letting them borrow your money, and in return, they are paying you interest over time. A higher Fed rate can lead to competition among banks and financial institutions to offer better rates on high-yield savings accounts.
Advice: Search for better savings account rates
To take full advantage of Fed rate increases, check the current interest rate of your savings account and look around for better options.
- Interest rates on Certificates of Deposit (CD) often increase as Fed rates rise. You may receive better rates with a CD than with a regular savings account, which is beneficial if you can commit to investing your savings for at least one year – CD rates are usually based on one, three, and five-year terms.
- Online and high-yield savings accounts may offer better interest rates than traditional savings accounts.
Reduced home purchasing power
Mortgage rates tend to be influenced by the 10-year U.S. Treasury bond rather than the Federal funds rate. When Treasury yields rise, investors in mortgage-backed securities demand higher rates to compensate for the greater risk of their investment. This usually results in an increase in mortgage interest rates for the consumer. According to Freddie Mac, the average 30-year, fixed-rate mortgage rose from 5.23% to 5.78% following the June 2022 Fed rate hike. However, interest rates in the first week of January 2022 were 3.22%, so interest rates had already increased significantly prior to the Fed announcement in June.
In response to the interest rate increase on July 27th, 2022, Mike Fratantoni, chief economist for the Mortgage Bankers Association, said the Fed’s rate hike might keep mortgage rates stable in the 5%-to-5.5% range for the rest of the year.
Higher interest rates impact the purchasing power of many homebuyers. Buyers who have budgeted to afford a specific monthly mortgage payment will have a reduced home purchase budget. The silver lining is that home prices, which posted a 20.9% year-over-year increase in May 2022, according to the S&P CoreLogic Case-Shiller U.S. National Home Price Index, have started to stabilize.
Advice: Stay with your home purchase plan
If you are a first-time homebuyer ready to purchase a home, keep searching for a home so you can obtain a mortgage before interest rates further increase. If your down payment savings goal is close, speak to a mortgage loan officer about loan programs that you may qualify for now, especially if you have good credit. You might find that you’re better off getting a mortgage with a lower downpayment and paying private mortgage insurance now, rather than waiting six months and buying with a higher downpayment when interest rates have further increased.
If you’re 6-18 months out from buying a home, stick to your plan. Focus on paying down your high-interest credit cards, saving, and building your credit. It’s more important that you have a great credit score than have saved a 20% down payment.
Homeowners with an adjustable-rate mortgage may want to consider refinancing into fixed-rate mortgages. Also, homeowners with conventional and FHA home loans with at least 80% equity should ask their mortgage loan officer to run the numbers to see if they would be better off refinancing at current rates to remove private mortgage insurance.
As the Federal Reserve continues to increase interest rates to fight inflation, knowing how interest rate hikes can impact your finances will help you make informed financial decisions. While paying down debt is important, saving money is just as important to avoid using credit cards to pay for unexpected expenses.
FinLocker provides tools and resources that help you create trackable budgets for saving money towards an emergency fund, down payment, and paying off debt. By managing your financial accounts in your FinLocker, you can see where and when you are spending your income and identify areas where you can reduce spending to save more. You can also monitor your credit and use tools to help build your credit, so you can be ready to qualify for better loan terms when you’re ready to apply for a mortgage.