May 25, 2022 – By Frank Corrado, CPA, CFP®, RLP.
The Federal Reserve has recently raised its short-term benchmark interest rate by a half-percentage point (between 0.75% and 1), the sharpest increase since 2000. Even though widely expected, the move will ripple through the economy and Americans’ financial lives.
Intended to combat the highest inflation in four decades, the higher rates will make it more expensive to buy a home or a car or carry a credit card balance. The Fed began increasing rates in March by one-quarter of a percentage point, after lowering them to near-zero levels during the pandemic. Wednesday’s increase will accelerate the impact on American wallets from gradual to more sudden.
In the past, rate increases and rate cuts were smaller and happened more slowly, when compared to today’s accelerated attempt to tame inflation.
Here is how the latest Fed rate change will affect your money, and what to look out for as more interest-rate increases are expected this year:
Mortgage Rates
Few interest rate benchmarks cause a change of behavior like mortgage interest rates. Tied directly to the affordability index for most homebuyers, the decision to buy a home or the amount to borrow depends on interest rates.
Over the last two years, low rates and low housing inventory ignited a fiercely competitive housing market. House hunters encountered higher prices and bidding wars.
Mortgage rates are mainly based on the 10-year U.S. Treasury bond yield. This rate is used as a benchmark for many loans, including mortgages. When the Fed raises rates, this pushes the yield on the Treasury note higher, which will then push mortgage rates higher. As the Fed signaled higher rates earlier this year, the 10-year yield increased. According to Freddie Mac, it raised the average rate on a 30-year fixed-rate mortgage to 5.27%, as of the week ending May 5. Just a year ago, the same rate was 2.96%.
Anxious house hunters should look at the broader historical context. It seems unlikely that mortgage rates will soar to the 18% level as they did in the early 1980s (yes, I got a “deal” at 18¼%). However, that may come as little consolation to buyers who have grown used to years of ultralow rates. Compared with decades past, a 5% mortgage rate is still considered low by historical standards.
And while mortgage rates are higher than they were one year ago, a 100 basis points increase in mortgage rates (1%) on a $100,000 loan equates to a $63 per month higher mortgage payment, over 30, years and should not necessarily prevent you from buying that special home!
Savings Accounts
While less happy for home-buyers, rising rates could mean good things for savers long saddled with minuscule rates of return on savings accounts and certificates of deposit.
Interest rates offered on many CDs and savings accounts often move with the federal-funds rate. During the pandemic, despite getting little return from banks, Americans hit the highest personal savings rate in generations.
While CD and Money Market rates are moving higher, don’t expect that these rates will move immediately. Banks have little incentive to offer higher rates on your savings given the broad trend in people socking money away, but it is an excellent time to “shop around.”
Credit Cards
Higher interest rates usually mean credit cards will get a higher annual percentage rate, or APR, so keep a close eye on your balance and the rate being charged by your credit card company. The average annual percentage rate for those with good credit was 18.84%, which could rise given the rate increases.
As a financial discipline, we educate clients on the “Wisdom of Borrowing,” which suggests a difference between “good debt and bad debt.” Credit card debt makes little economic sense as interest rates rise – even with the points or miles!
A New Car
The rate increase shouldn’t surprise those who have already secured a fixed rate for their auto loans. These loans typically have a fixed-interest rate pegged to Treasury yields. If you are shopping for a car, you might see higher costs during the purchasing process, depending on how you finance the car.
Financing is a key profit center for dealerships, which collect a portion of the interest rate or a fee when they arrange a loan or lease on behalf of a bank, auto company, or another financial firm. The financing makes it easier for dealers to sell high-margin add-on products like insurance and warranties. The car market remains hot, so be sure to do the math on “hidden costs” before purchasing a vehicle.
Student Loans
Borrowing money to help pay for a college education is considered “good debt” under the assumption that the course of study will provide the requisite “intellectual capital” to leverage higher future earnings.
Interest rates have already been set for the 2021-2022 school year for those with federal student loans, so the current increase won’t affect borrowers. According to the U.S. Department of Education, a direct subsidized and unsubsidized undergraduate loan rate is 3.73% until June 2022.
The student-loan pause that went into effect in March 2020 halted interest accrual and gave some borrowers a break from their regular monthly payments. For some, this provided a chance to eliminate their debt. The pause has been extended to August 2022.
The interest rate for federal student loans is set every May according to the 10-year Treasury note auction. These rates are fixed for the life of the loan. Next year, however, the rise in rates could impact loans distributed for the following academic year.
However, private student loans charge interest rates that are fixed, stay consistent or are variable, which can increase or decrease depending on the institution you borrow from or your financial circumstances. These could be affected by The Fed’s decision, leading to those borrowers facing higher interest rates.
Conclusion
For about 35 years, investors have enjoyed a bull market in bonds. At the start of 1982, the interest rate on 10-year U.S. Treasury bonds was 14.2 percent. By November 1, 2016, interest rates had fallen to 1.8 percent. The Federal Government supported the economy during the 2008/2009 crisis with company bailouts and reduced interest rates. The level of liquidity in the market, combined with the low cost of borrowing, has fueled the spike in inflation.
The Federal Reserve is tasked with fostering economic prosperity and social welfare. Congress has given the Fed a mandate to keep prices stable – that is, to keep prices from rising or falling too quickly. The Federal Reserve sees a rate of two percent per year as the right amount of inflation. Until inflation moderates and moves toward the market expectation, you can expect your cost of borrowing to remain at elevated levels.