In June, some very important people will meet to make some decisions that will reroute the trajectory of the U.S. economy. The “Fed,” led by Federal Reserve Chair Janet Yellen, will have one decision circled on their agenda that will affect millions of Americans: to raise interest rates.
A bump in the federal funds rate shouldn’t be taken as bad news. After all, we’ve enjoyed unprecedented historic lows since 2008, when the Fed slashed interest rates to buoy a sinking economy, to a range of .0% – .025%. Never before had they set it at a range instead of a specific number, but 0% was technically problematic because money market funds couldn’t operate with a true 0% rate. It’s stayed at the range of .0-.025% ever since.
But it will send a ripple through almost all of consumer lending and personal finance, raising payments on mortgages, credit cards, and auto loans, among others. To prepare for the rate bump, economists and financial analysts are already imploring people to improve their credit scores and take advantage of the current low interest rates while they’re still around.
What is the “Fed”?
What’s commonly referred to as the “Fed rate” or “Feds raising rates” actually references the federal funds rate. It’s the interest that banks and other financial institutions pay when lending money to each other, usually on an overnight basis. Therefore it sort of acts as a faucet to turn on and off the flow of funds and lending by influencing interest rates.
Since the fed fund rate has been at historical lows for such a long time, there really is nowhere for it to go but up. It’s no secret that the increase will happen this year, as the Fed has all but guaranteed it in past statements, especially since the economy is showing robust signs of health. Analysts forecast a slow and incremental increase, possibly with a quarter to half point bump as the Fed meets the rest of the year, resulting in about a one-percentage point total increase by mid 2016 or later. Over the next couple years after that it’s expected to keep rising, possibly as high as 4 percentage points.
What does it affect?
So why should we care so much about the Fed raising interest rates? The Federal Reserve doesn’t set interest rates for lending, banks, and commerce directly, but the major indexed rates, like the widely used prime rate, mirror it almost identically. So a rise in the federal funds rate means we’re going to see a corresponding increase in the prime rate, which is the base rate that money may be lent out commercially. And the prime rate does dictate the interest rates we use every day, such as APRs on credit cards and adjustable mortgages.
Like we mentioned, the FFR was set so low when the country was in crisis mode, there was no where to go but up. But the Fed also raises the rate to ease inflation as the economy grows. The Federal Reserve is encouraged by strong jobs and unemployment numbers, a main indicator, and sees a gradual increase as absolutely necessary to our long-term economic balance and health.Who will lose when the Fed raises rates?
Most lending products that are tied to the prime interest rate will be more expensive when the Fed increases rates, like adjustable mortgages and HELOCs, credit cards, some car loans, and business lending tied to the prime rate. It will also have a profound effect on the housing industry (less people buy or can refinance when mortgage rates go up) and the stock market.
Consumers who carry debt on their credit cards will see their payments go up when the Fed raises rates. Most credit card APRs are tied to prime.Americans will pay as much as $7.6 billion more annually on their credit cards, based on an analysis of industry records and Federal Reserve projections. So, for example, if your credit card’s annual percentage rate is designated as 10% plus prime (3.25% now,) you are currently paying 13.25%. But that will go up quickly once the federal funds rate, and then prime, rises. According to Transunion, there are about 158 million U.S. cardholders with balances total $763 billion now, which means that even a small 1% increase in prime will cost the American people $7.63 billion more in yearly payments.
While it may not add up to large payment increases for most people with low or moderate credit card debt, for people with 20k or 50k of debt, who are already overwhelmed, an extra few hundred dollars in payments every month could send them over the edge of financial feasibility.
Adjustable mortgages and HELOCS.
Most adjustable rate mortgages are based on the prime rate or similar indexes, so people who have these mortgages will see payment increases once the Fed raises rates. Additionally, home equity lines of credit are usually based on prime, and with 18 million HELOC loans still outstanding in the U.S. with an average balance of $30,000, mortgage holders will feel the pain.
People who need mortgages.
“People thinking of buying a house should act quickly to lock in today’s low rates,” says Dean Croushore, professor of economics at the University of Richmond and former Philadelphia Fed economist. As the Fed raises rates, mortgage rates will climb accordingly, making it more expensive and harder for consumers to qualify. This will also effectively end the golden year(s) of refinancing we’re experiencing, as rates are near record lows and more people have equity.
Most auto loans are tied to the prime rate, too, so the cost of financing a car or making your existing car payment will go up.The stock market.
The stock market has surged based on jobs numbers and the Fed not raising rates after their April meeting, but a steady diet of rate increases to come will surely shake the markets with volatility. Wall Street has been thriving but everyone sees it’s set for a natural correction (a drop of 10% or more) and Fed rate movement very likely will trigger it.
People who are walking a financial tightrope.
According to a survey conducted by the Consumer Federation of America early this year, households have less savings than they did back in 2010. In fact, 64% of respondents reported that they don’t have adequate savings to deal with an unexpected setback like a job loss, medical problem, or big expenditure. So if rates go up and their credit card, auto, and mortgage payments all jump at the same time, it may imbalance a lot of budgets and send a lot of already overextended people further into debt – or bankruptcy.
So who will win when the Fed raises rates?
Essentially, we all will, because the Fed pumping the brakes on the economy is largely considered a good thing, alleviating inflation concerns and deflating risk of growing too fast. Also, savings accounts, which pay a paltry 0.44% interest right now, will offer more gains.
But the real winners will be people with high credit scores, as they’ll still be able to take out the best rates on mortgages, credit cards, auto loans, and even shop for fixed rate products that aren’t tied to prime – or impacted by the federal funds rate.
