Consumers are already feeling squeezed by higher prices on daily necessities, whether it is at the gas pump or in the supermarket. And now that interest rates are ticking higher, the cost of borrowing — from credit cards and car financing to private student loans — will increase, too.
By increasing its benchmark rate a quarter of a point Wednesday, the Federal Reserve is trying to rein in inflation, which is at a 40-year high. The mechanics are relatively straightforward: By raising its federal funds rate — the rate banks charge one another for overnight loans — the Fed sets off a domino effect. Whether directly or indirectly, a number of borrowing costs for consumers go up. In theory, this slows demand for goods and taps the brakes on inflation.
The rate increase was the first bump in the benchmark rate since the pandemic gripped the world in March 2020 and pushed the rate to nearly zero. But the global economic situation is only slightly less complicated today than it was when the coronavirus closed down large swaths of the global economy. Supply chain problems have persisted, and Russia’s war in Ukraine has roiled the markets for oil and natural gas.
The Fed is anticipating more rate increases as the year goes on. For now, consumers may feel the sting of higher prices more acutely than the pain of a quarter-point bump. But the effects of the Fed’s moves will be more pronounced the further the central bank goes.
Mortgage rates do not move in lock step with the federal funds rate but instead track the yield on 10-year Treasury bonds, which is influenced by a variety of factors — including how investors expect the Fed to react to inflation.
Mortgage rates have already been ticking higher as a result of inflation, even though they remain historically low. Rates on 30-year fixed-rate mortgages averaged 3.85% with 0.8 points as of March 10, according to Freddie Mac, up from 3.76 last week and 3.05 a year ago. (A point is a one-time fee, equal to 1% of the mortgage amount, paid to the lender to buy down the mortgage rate.)
“The pain to the consumer from accumulated hikes probably doesn’t start to bite until several rate increases are in place,” said Keith Gumbinger, vice president at HSH.com, which tracks the mortgage market. “But at the same time, rates could rise considerably from present levels and still be considered low by historical standards.”
Gumbinger said he expected the 30-year fixed-rate mortgage to “crest over the 4% mark this week,” pressured upward by inflation, which is pushing long-term Treasury rates higher (and pulling mortgage rates along).
Other home loans are more closely linked to the Fed’s move — including home equity lines of credit and adjustable-rate mortgages — and will generally move higher the next time an individual loan resets its rate.
Changes in credit card rates will hew closely to the Fed’s moves, so consumers can expect to pay more on any revolving debt. The average interest rate was 16.44% for cardholders who did not pay off their balance each month at the end of last year, according to the Federal Reserve.
Higher rates tend to be passed along within one to two statement cycles, said Greg McBride, chief financial analyst at Bankrate.com. For people carrying debt, he suggests considering a zero percent balance transfer, some of which last as long as 21 months.
“This will insulate you from the rate hikes we expect over the next 18 months or so,” he said, “but also give you a clear runway to get that debt paid off for good without facing the headwind of interest charges.”
Current federal student loan borrowers are not affected because those loans carry a fixed rate set by the government (loan payments and interest accruals continue to be paused until May). New batches of federal loans are priced each July, based on the 10-year Treasury bond auction in May.
Private student loan borrowers, however, should expect to pay more; both fixed and variable rate loans are linked to benchmarks that track the federal funds rate.
Variable loans will generally move higher first. But private lenders will begin to price additional expected increases into their new fixed-rate loans, said Mark Kantrowitz, a student loan expert and author of “How to Appeal for More College Financial Aid.”
The Fed is widely expected to raise the funds rate several times over the next couple of years, and private lenders could soon start baking those expectations into their interest rates — meaning borrowers could end up paying anywhere from 1.5 percentage points to 1.9 percentage points more, depending on the length of the loan term.
Prices for new and used vehicles have skyrocketed so much in the past year that interest rates may seem like an afterthought. But these rates are also expected to rise.
The average interest rate on new car loans was 4.39% in February, relatively flat from a year ago, according to Dealertrack, which provides business software to dealerships. The average for used vehicles was 7.83% in February, down from 8.25%.
Car loans tend to track the five-year Treasury, which is influenced by the federal fund rate — but that is hardly the biggest factor in determining the rate you will pay.
The rate a borrower qualifies for depends on credit history, the type of vehicle, the loan term, down payment and other factors. Borrowers with poor credit scores may pay 20% or more, while those with pristine credit might qualify for rates near zero, said Jonathan Smoke, chief economist at Cox Automotive, an industry consulting firm.
“There is far more variation in auto lending than in, say, the mortgage market because there are more credit types,” he added. “Anyone can get an auto loan.”
Although the typical car payment has reached its highest levels since 2012, the latest increase is not expected to make a meaningful difference — at least not yet.
“Car loan rates will move up as the Fed hikes interest rates, but it will be a nonissue for car buyers because it has such a limited impact on monthly payments,” said McBride, adding that the difference of a quarter percentage point on a $25,000 loan is $3 a month. “Nobody will need to downsize from the SUV to the compact because of rising rates,” he said.
Savings accounts, CDs and more
Many people stashed extra money in their bank accounts over the past couple of years, but whether rate increases translate into a more attractive yield depends on the type of account you have and the institution you are doing business with.
An increase in the Fed benchmark often means banks will pay more interest on deposits — but not necessarily right away. Banks tend to raise rates when they want to bring more money in, but the largest banks already have plenty of deposits. That gives them little incentive to pay depositors more.
Smaller banks and online banks tend to pay better rates more quickly than larger institutions, according to Ken Tumin, founder of DepositAccounts.com, part of LendingTree. And some of them, particularly the savings arms of credit card banks including Capital One and American Express, have already begun increasing their rates a bit, he added.
But overall, rates remain quite low. The average online savings account was paying just 0.49% in March, according to DepositAccounts.com; the average was 0.48% a year ago. At brick-and-mortar banks, the average savings account paid 0.12% in March, down slightly from 0.15% the year prior.
Certificates of deposit, which tend to track similarly dated Treasury securities, have already begun to move a bit higher, particularly among online banks. The average one-year CD at online banks is 0.67% in March, up from 0.51% in January, while the average five-year CD is 1.08%, up from 0.86% in January.
Most money market mutual funds, which tend to hold lower-risk investments like short-term government securities, are also expected to rise, albeit from a rock-bottom rate. Most money market fund yields are below 0.02%. “They usually respond fairly quickly to changes in the federal funds rate,” Tumin said.
Stocks and bonds
The world remains an uncertain place, and the stock and bond markets will continue to react to all of it — Russia’s war on Ukraine, the ebbs and flows of the pandemic, inflation, energy prices or what the Fed does next.
If you are a long-term investor, you are reaching for a goal at some date in the future — and your portfolio should include just enough riskier investments (stocks) offset by some more stabilizing ones (bonds) to get there. In other words, it should be built for rocky periods like these — and if that is the case, it is better to look away and focus on what you can control.
The stock market has already priced in expectations for multiple increases this year, so any market reaction Wednesday is just a short-term blip. But investors will be closely watching for any hints the Fed is going to slow down or speed up the next increase.
Bond investors often worry at moments like these because when rates rise, the price of existing bonds fall. That is because older (lower-yielding) bonds are not as attractive as those shiny new bonds offering a higher rate. But people who own bonds in vehicles like mutual funds will eventually benefit as the funds reinvest money in higher-yielding bonds.
Most people with bond investments hold them through some type of mutual fund. To get a sense of how your fund may react to rising rates, take a look at its duration, a number that you can look up on your fund provider’s website. It is a complex calculation that combines interest payments and the bond’s maturity date to measure the investment’s sensitivity to rate changes. The longer the duration, the more sensitive the bond.