What a Federal Interest Rate Hike Means for You
The Federal Reserve is very likely to push through a rate hike as soon as this week.
Like a lot of big economic policy decisions, it may be difficult to see how exactly that kind of change will impact your day-to-day life. But these rate changes are rare because they can have major trickle down impacts on consumers and businesses across the country. So with that mind, let's take a look at the federal funds rate, why it may go up, and what that means for you.
What is the federal funds rate?
To understand the potential impact of a rate hike, first you need to know a little bit about the federal funds rate. Financial institutions are constantly lending money back and forth. In every transaction a new interest rate is negotiated. The federal funds effective rate is the weighted average of all of these interest rates.
The Federal Reserve, meanwhile, looks at the overall economic landscape and decides what they believe would be the ideal interest rate for our current, national economy. This is called the federal funds target rate. The Federal Reserve then uses something called open market operations – usually the buying and selling of government bonds – to manipulate the flow and availability of money until the effective interest rate aligns with the target interest rate.
So when we say there will be a rate hike that means that the Fed is going to take certain actions to drive up the effective rate until it hits their predetermined target.
Why would the Fed raise interest rates?
The simplest explanation for why the Fed would want rates to increase is to combat inflation. High inflation generally means that demand for goods and services is high, but supply is low, causing the price for those goods and services to skyrocket. When you can't fight inflation by increasing supply, your only option is to decrease demand.
A federal rate hike reduces inflation by:
- Increasing the cost of borrowing
- Making loans and mortgages more expensive
- Which makes businesses and consumers less likely to finance big purchases
- Which drives down demand
- Which should bring down costs and reduce inflation
When the economy plummeted in 2008, the Fed dropped interest rates way down in the hopes that it would induce growth. The thought was that lower rates would make it easier for consumers to get back to spending and investing. It worked, too (more or less).
The risk with increasing interest rates, however, is it can potentially slow down economic growth too much, causing businesses to stop expanding, adding fewer jobs (and possibly even losing jobs), while consumers reduce spending too sharply. That's why the Fed doesn't make these kind of rate changes often or without a lot of deliberation.
What does a rate hike mean for you?
Long-term, the hope is that a rate hike will slow, stop, and eventually reverse inflation, dropping prices on consumer goods across the board. But the ultimate impact of a rate hike can be complicated, with potential effects across a range of financial products.
Variable-rate credit cards, HELOCs, and other loans will become more expensive. If you're carrying a balance on a loan product with a variable rate, your interest payments are very likely to increase.
Fixed-rate loans and mortgages will stay the same. If your loan products have a fixed rate, a federal rate hike won't impact those existing loans.
New loans will be more expensive. Getting a new auto or personal loan after a rate hike will be more expensive, even if your credit score is pristine.
Rates on savings accounts may also go up. Beyond the promise of prices eventually dropping, the biggest consumer benefit of a federal rate hike is that banks and credit unions may start offering higher yields on savings account, money-market accounts, and CDs, helping your money grow more rapidly.
How to prepare for a federal rate hike
Again, the ultimate hope for a rate hike is that prices come down and life starts to get a little more affordable. But the immediate impact is that the cost of borrowing money is going to go up, so if you need a loan or if you've already got debt with a variable interest rate, that debt's going to be more expensive.
If you have substantial credit card debt, you may want to consider taking active steps to reduce that debt load. Increased interest rates mean increased interest payments on outstanding debts. So if you’re struggling to manage your unsecured debt already, things aren’t going to get any easier.
Now is really the best time to consider your options and create a plan to reduce your debt load. That might mean utilizing consolidation loans, balance transfers, or a debt management plan (DMP) as part of your effort to burn debt quickly. With a DMP from MMI, the average interest rate for included debts is below 8%.
If you’re carrying a high level of debt and would like help understanding your options, consider working with a certified financial counselor. MMI offers free financial counseling online and over the phone, 24/7. We'll help you create a plan customized to your debts and goals.
