The Federal Reserve has repeatedly stated that rates are headed upwards as the economy begins to improve. Short term interest rates have sat at all-time lows for over 6 years and the upcoming increase can set off a chain reaction of financial trouble if you are not prepared. The question is not if, but when. Once they begin to rise, it is anticipated that they will increase gradually over the next several years which could result in the doubling of the Prime Rate.
What the Federal Funds Rate Actually Means
The Federal Reserve controls the federal funds rate, which is the rate banks charge each other for overnight funds. For the last 112 months the federal funds rate has remained near zero due to the extended recession and very slow economic recovery many families are still feeling.
As unemployment declines and spending increases, inflation tends to rise as the cost of living goes up. Raising rates is believed to offset inflation which has been below 2% for the last several years. As a result, consumers have enjoyed cheap money and in many cases taken on more debt and higher spending levels as a result.
The Federal Funds rate is a short term rate that does not directly correlate with long term rates like mortgages, but mortgage rates will generally increase when the interest rates rise. The stock market, bond rates, and the overall economy will feel the effects of a rate increase for both short term and long term markets.
Who Are the Winners When Interest Rates Rise
The winners of a rate increase are conservative investors. Those who want to invest in CD’s and treasuries will see an increase in income as rates rise and CD’s renew. This can impact the income of seniors who are traditionally the most conservative investors. Since 2009, many conservative investors have either limited their returns by remaining in investment vehicles paying near zero or increased their risk tolerance by moving funds to more aggressive investments like dividend paying stocks or bond funds.
Who Are the Losers When Interest Rates Rise
Losers are those who are currently carrying variable debt, those looking for new loans and those who hold current bonds.
Variable Debt is generally tied to the Prime Rate from the US or the LIBOR Rate out of London, UK. Prime rate is based in the US and rises in direct proportion to an interest rate increase by the Federal Reserve. It is a benchmark for most credit card interest rates in the US. The LIBOR rate is based in London, has similar indexes when rates rise overseas, and is often used as the index for variable rate mortgages. The Prime and LIBOR rates are the rates banks charge their best customers and serves as an index or benchmark for most variable rate products.
Most credit cards interest rates are variable and will be directly impacted when the Federal Reserve raises rates. If the Federal Reserve raises rates by ¼ of a point from .25 to .50 (Federal Funds Rate), then the Prime Rate will move from the current 3.25 to 3.50 as early as the next month. The result will be higher minimum payments, almost immediately.
Variable rate loans, mortgages, and equity lines of credit will also be impacted depending on the rate change cycle. Some rates will go up the next billing cycle (credit cards and equity lines of credit are common). Other rates are locked in for a certain time period. When that period expires then the rate will adjust. Adjustable rate mortgages are typically locked in for a set time period.
New Debt Borrowers will see increases in borrowing costs as new loans are issued at higher rates. This will impact car loans and home loans in particular. Loan approvals depend on debt to income ratios as a primary key to loan qualification. Higher rates will mean that with the same income you will qualify for a lower loan amount because more of the payment will go to interest.
Current Bond Holders will see the value of their bonds decline because new bonds will be issued at a higher rate. Bonds almost always have an inverse relationship with interest rates because bonds represent the borrowing cost of the company that issues the debt. (When you buy a bond you are lending the company money and they pay you back with interest). If a current bond is paying 3% and the rates increase, then new bonds will be at a higher rate. This devalues existing bonds.
How to Protect Yourself
The number one thing to do is know which rates are fixed and variable on all your current debt.
Student loans. Non-consolidated student loans may be variable and reset each July. A consolidation loan can combine all the loans into a single loan and give you a single fixed rate for the life of the loan. It is easy to qualify for a consolidation and generally no income qualification is required. If payments are a struggle, consider signing up for an income based repayment plan that will set payments based on your income. This will extend payments further out and result in more interest over time, but can provide immediate relief. This payment plan must be renewed each year and you can change repayment plans when your financial situation improves.
Credit Cards are almost always variable rates based on Prime, unless you are under a special financing program. This means as soon as rates go up your minimum payment will also rise. To combat this you could contact each company and request a reduction in your current rate. This is most effective if you have not missed a payment in at least 12 months. A rate reduction will reduce the margin and minimize the damage of a rate increase. Other solutions include paying the debt off or refinancing it into a lower fixed rate loan.
Car Loans are typically fixed rate loans, which will not be impacted by a rate increase as long as the loan is issued before a rate increase.
Mortgages can have fixed or variable rates. Typically, variable rates are 1, 5, or 7 year ARMS. The rate is fixed for 1, 5 or 7 years and then adjusts each year afterwards. The ARM rate will reset at the same time each year. At each reset the new rate will reflect any rate increases. Due to large balances on mortgages, a small rate increase can have a noteworthy impact on your monthly payment. Over time, consistent rate increases can lead to significantly higher mortgage payments.
Refinancing is the only way to move to a fixed rate mortgage. If you are overextended, underwater, had late payments, or have difficulty proving income a refinance may be hard to come by. Sometimes current lenders offer a streamline mortgage that may be easier to qualify for and have lower closing costs than a traditional refinance.
If you are currently struggling with payments, being proactive is the best solution. Working with a credit counselor or debt management firm will allow you to review options and make sound financial decisions that can mitigate the impending rate increases.