The Consequences of Rising Rates: How a Higher Interest Rate Affects You

The Federal Reserve Bank recently nudged interest rates higher, increasing the federal funds rate to a range of 0.75 percent to 1 percent.

The boost to the Fed’s benchmark interest rate wasn’t unexpected, and officials have indicated there are more increases to come. After providing stimulus in the form of low interest rates over the past nine years as the U.S. economy recovered from the Great Recession, the Fed has decided it’s time to reverse course.

In the broader sense, this is good news. It signals that a sustained economic expansion is underway. Still, there’s some fear that a rate increase could hurt the economy. People traditionally spend less when rates rise, and higher interest rates could cause consumers to rethink big purchases like a new home or vehicle. When people stop spending, the economy takes a hit.

For consumers and small business owners who use loans and credit cards to make ends meet, some adjustments could be warranted when it comes to taking on new loans and managing existing debt.

The Effects of Rising Rates

Whether you’re in the market for a new home or simply have several credit cards, the Fed’s recent rate increase will likely affect your finances in some way. The extent of the rate hike’s impact on your pocketbook could vary significantly depending on your personal situation, as each debt category reacts slightly differently to interest rate moves.

Here’s everything you need to know to make better decisions regarding your borrowing activities:

• Credit Cards Credit cards are versatile cash management tools that are best suited for short-term borrowing. As long as you pay your bill in full each month, you effectively have access to a 30-day loan on an interest-free basis. Credit cards also help you build your credit score, provided you’re making payments on time and keeping your balance well below your credit limit. Those benefits disappear quickly once you start to carry a balance from month to month. Credit card interest annual percentage rates tend to be higher than interest rates of other lending methods, and the APRs rapidly adjust to Fed rate bumps. In fact, most credit cards likely posted an interest rate increase of about 0.25 percent immediately after the Fed’s announcement. Be particularly mindful of your outstanding credit card balance moving forward, as an environment of rising rates can accelerate debt in the blink of an eye.
• Home Loans Homeowners who were on the fence about selling or potentially making a new purchase might want to accelerate their plans before rates rise further. As rates increase, it becomes less affordable to buy a home. A boost in interest rates often leads to stepped-up activity in the housing market, with buyers trying to push through purchases while mortgage rates are still relatively low. For their part, sellers tend to market their homes more aggressively when buyers are so active. When it comes to financing, homeowners who have already locked in a fixed-rate mortgage are unaffected by rate increases. Homeowners who have used variable rate mortgages or those with second mortgages — home equity lines of credit — might want to refinance into fixed-rate loans. Variable rate loans adjust immediately to each rate increase. To give you an idea of how much your monthly payment adjusts, a 0.75 percent rate increase on a $200,000 loan — from 5 percent to 5.75 percent — could boost monthly loan payments by up to $100.
• Student Loans People who might not otherwise be able to attend college or graduate school are able to seek higher education thanks to student loans. Aside from being an investment in your future, these loans can help you establish a strong credit history. Evidence that you can borrow a significant amount of money and repay it helps establish and boost your credit score over time. When interest rates rise, existing federal student loans are not affected because their rates are fixed. Any borrowers who finance their education using adjustable rate private loans could face higher rates and payments, though. If you have outstanding college debt, you should consult your paperwork to figure out which benchmark governs your loan.
• Business Loans Entrepreneurs often turn to business loans to manage how cash flows through their companies. Business loans play a major role in enabling growth, as companies use them to purchase supplies, services, and labor. When the Fed increases rates, it directly affects short-term loans. Loans offered by the Small Business Administration are subject to terms negotiated between borrowers and lenders, but their rates are partially based on short-term rates. The higher short-term loans go, the more expensive business loans become. This is simply a cost of doing business, so many firms will be forced to adjust their prices to offset the increased expense.

The Fed’s interest rate hike certainly isn’t all bad news. Mortgage rates, credit card APRs, and adjustable interest rates will likely rise, but savers could enjoy some slight benefits. People who have savings in money market accounts, for example, benefit from rising rates whenever the Fed approves an increase.

Credit is a phenomenal economic tool, but it’s critical to understand the particulars of each lending method to ensure you’re not caught unaware when rates fluctuate. With the Fed planning additional increases later this year, it’s more important than ever to be on top of your financial game.