What a Fed Rate Hike Means for Borrowers, Savers and Home Buyers

What a Fed Rate Hike Means for Borrowers, Savers and Home Buyers

The Federal Reserve kept interest rates low throughout the first two years of the COVID-19 pandemic, but increases seem inevitable as early as March 2022 in an effort to curb inflation.

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That means rates on familiar financial products like savings accounts, mortgages and credit cards are likely to rise.

Interest rates have been low for so long that many consumers - millennials and Gen Z, particularly - haven't really known a time when borrowing wasn't cheap and savings vehicles didn't pay next to nothing.

Strictly speaking, the Fed can change only a single rate: the federal funds rate. This rate determines how much interest financial institutions charge one another to borrow money overnight. But because so many other rates in the economy are tied to the funds rate, any increase by the Fed has a direct effect on the interest consumers pay when they carry a credit card balance or take out a loan, and on yields for savings accounts and certificates of deposit.

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In general, the Fed reduces rates to try to stimulate the economy and raises rates to try to head off inflation. A Fed forecast in December 2021 suggested three rate hikes could be ahead in 2022.

Here's what you can expect, and how to position your finances in a rising-rate environment.

Higher returns for savers

In general, higher interest rates are good news for savers and bad news for borrowers.

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Savings accounts, in particular, have produced paltry returns in recent years. Certificates of deposit have not fared much better. Many savers have squeezed a bit more interest from their accounts by shopping for higher-yield online savings accounts, which tend to offer better returns than traditional bank accounts.

These historically low rates on savings products won't jump higher overnight, but a higher federal funds rate can stimulate competition among banks and credit unions, and consumers may benefit from that. It may be worth looking for an account with better rates if your financial institution is slow to respond to a Fed rate increase.

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More expensive debt

Interest rates on credit cards are typically not fixed, so they're especially vulnerable to changes in the federal funds rate. If you're carrying credit card debt, you can probably expect your interest rate - and also your minimum payment - to rise. That will make it harder to chip away at the debt.

But there are moves you can make to take the sting out of climbing credit card interest.

Reducing your credit card debt aggressively is a good idea no matter what rates do. Re-evaluate your budget to see whether you can free up any cash to pay down your credit card balances, and think about whether you can increase your income, even temporarily.

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As interest rates rise, ensure you're making at least the minimum payments on time, on every card. This will help strengthen your credit score over time, which will make it easier to qualify for lower-interest loans.

If you do have good credit, consider moving higher-interest debt to a balance transfer credit card. These offers may become scarcer if the Fed continues to raise interest rates, and locking down a 0% intro APR for 12 months or more is a great way to make a significant dent in your debt. Paying down your balances will also improve your credit score.

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If you plan to borrow money in the near future, you can expect to pay a higher interest rate on auto loans and personal loans if rates rise. Double-check that your existing loans have a fixed interest rate, and consider borrowing sooner rather than later to keep your interest costs down.

If you own a home, you may be able to borrow equity to pay off your credit cards. But be careful - home equity lines of credit, which often have variable interest rates, are also likely to be affected by the Fed's rate hike. Consider instead a fixed-rate home equity loan, or refinance your primary mortgage to pay off your credit card debt and lock in a low fixed rate now while you still can.

A slower impact on homebuyers

Mortgage rates already have been rising in anticipation of Fed rate hikes, and they likely will go up even more through the end of 2022.

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The Fed's rate increase will end what has been effectively a zero-interest-rate environment, because the federal funds rate has been so close to zero for so long. These historically low mortgage rates jolted upward by almost half a percentage point in January as the Fed’s intentions came into focus. Even after that increase, mortgage rates were still low by the standards of previous generations of homeowners.

However, if the Fed continues to boost short-term rates over the next two to three years - and inflation climbs - homebuyers will see mortgage rates rise significantly.

It's important to consider that even incremental rate increases are costly when imposed on big-ticket items like homes and stretched out over the life of a multiyear loan.

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For instance, a 30-year mortgage at a rate of 3% on a $300,000 loan yields a monthly payment of about $1,265. A rate of 5% bumps that to $1,610 - and adds almost $145,000 in interest over the life of the loan. When higher rates are combined with rising home prices, it's easier to get priced out of the market, especially for first-time buyers.

Getting ahead of the tide of rising interest rates can save borrowers thousands of dollars. Consumers with adjustable-rate mortgages and home equity lines of credit should take a close look now at their financing options, and consider moving to currently low fixed-rate alternatives.

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A rising rate environment

Once the Fed decides on a rate hike, it will then be watching closely to see how that hike affects the economy. If the job market and other financial indicators remain strong, you can expect rates to keep inching higher.

Such an initial rate bump would be an opportunity to prepare yourself for a possible trend toward higher rates. Reducing debt, especially when you're paying a variable interest rate, will help you get ready for a rising-rate environment. So will increasing your savings and staying focused on your long-term investing strategy, in spite of day-to-day fluctuations in the stock market.

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