In an announcement Wednesday, the Federal Reserve opened the door to raising interest rates in the next few months. While borrowers may realize that could have an impact on them (and it likely does), it’s difficult to see who actually wins and who will be spending more on interest payments in the coming years. How does the decision of the nation’s central bank affect your wallet? And why is it such a big deal to be talking about changing the rate now?
The Fed is responsible for making sure that the economy has a fighting chance to bounce back after times of struggle, most recently during the Great Recession. Through the federal funds rate target, the Fed influences the prime rate, a benchmark that individual banks use for many types of loans. When the prime rate is low, customers theoretically have more incentive to borrow money since the cost of loans are lowered, helping to stimulate the economy. As the central bank raises the federal funds rate target, the prime rate begins to rise and interest rates on all kinds of loans start to increase.
In an attempt to boost the labor market, increase borrowing, and free up consumers to spend more over the past several years since the recession began, the Federal Reserve slashed its federal funds rate target to 0-0.25%, commonly referred to as Zero Interest Rate Policy (ZIRP). The Federal Reserve has used this policy since the end of 2008, but indicators from the most recent Federal Open Market Committee, or FOMC (the group that determines if interest will rise), show that the rate could increase in 2015.
Rates on the rise?
On Wednesday, the FOMC removed the term “patient” from its official statement, which it releases eight times a year about the state of the economy. Instead, it said an interest rate hike is “unlikely” for its April meeting, which points toward possible increases in June or September. An overwhelming majority of the board members expect interest rates to rise in 2015, as 15 of the 17 members indicated some kind of increase. But the statement Wednesday also shows the interest rates could be more gradual than some analysts have predicted.
“In determining how long to maintain this target range, the Committee will assess progress — both realized and expected — toward its objectives of maximum employment and 2 percent inflation,” the FOMC statement reads. In short, the committee wants to make sure unemployment continues to drop, and inflation reaches a 2% level before increasing the interest rates. Both are indicators of a relatively healthy economy, and the Fed has a responsibility not to raise interest rates too quickly, or risk seeing another spike in unemployment.
Whether the Fed raises interest rates by 0.75%, what they’ve most recently predicted, or to a more subtle 0.25%, as some analysts assume, consumers will be affected. In many cases, people will pay more out of pocket when the rates increase. Here are a few examples of who could lose and pay more, as well as two groups who will likely see a benefit from the increases.
1. Lose: Credit card users with high balances
Credit card interest rates are tied to how much the Fed influences the prime rate. And most credit cards have APRs that are variable, meaning they change every time the prime rate does. “I don’t think consumers realize what a good deal they’ve had for so long,” Brian Riley, research director at the analysis firm CEB TowerGroup, told creditcards.com. The report assumed the Fed will raise interest rates by 1% over the course of 2015. Based on that, the average APR on credit cards with a balance this year will go to nearly 14%.
Because the APRs are directly affected, the interest rate increase will be applied to existing balances, as well as to new purchases. This isn’t a big deal for people who don’t carry a balance on their credit cards, as they will be virtually unaffected. But about 9 million people have credit card balances of $20,000 or more, TransUnion told the website. An increase of 1% from the Fed would likely mean an increase of about $7.63 billion a year in extra interest costs, with much of that shouldered on those people with higher balances.
2. Lose: New home buyers/mortgage holders
For people with fixed-rate mortgages, the changing interest rates won’t affect their monthly bill. But for those people trying to secure a fixed mortgage, or attempting to refinance, the rates will likely creep up ahead of when the Fed actually makes an official change. “Fixed mortgage rates are still below 4 percent, and that’s not likely to persist the closer we get to the Fed raising short-term interest rates,” Greg McBride, chief financial analyst for Bankrate.com, told CNBC.
For people looking to buy a new home, the anticipation of increased rates — even before they happen — is sometimes enough to convince people to move now. That drives up competition, said Keith Gumbinger, a vice president at mortgage information site HSH.com. “That could worsen the problem of finding a house you love at a price you love,” he told CNBC.
3. Lose: Lease holders/new car buyers
Auto loans are “profoundly” affected by the Fed’s interest rates, Bankrate.com reports. But the rates you see on your car loan don’t change dramatically with every FOMC report or federal funds rate change. Instead, it’s a combination of other market factors, including resale value of used cars and expectations for the inflation rate. In the recession, the factors aligned to benefit car buyers, said Paul Taylor, chief economist at the National Automobile Dealers Association.
Still, the rates do affect car loans to some degree, as you’re typically borrowing from a bank that will see its own borrowing rates climb. “There’s definitely a reason to think that if rates rise, it could have a rapid hit to car buying,” said Karl Brauer, senior director of insights for Kelley Blue Book, to CNBC. Brauer added that more people take out car loans because transactions prices have also increased in recent years. Consumers with lease contracts could also be affected, Brauer said, and suggested people with six months or less left on a lease should consider trading in their car ahead of a Fed interest hike. Locking in a fixed rate lease ahead of an announcement could mean a lower interest rate for the life of the lease.
4. Lose: Student loan borrowers
Federal loan rates are fixed, so college students who have already secured their loans won’t see an increase. Undergraduate direct subsidized and unsubsidized loans disbursed between July 1, 2014 and July 1, 2015, are locked in at 4.66%. Federal loan rates are set by Congress, and have more to do with the sale of Treasury note sales in May than the Fed’s rate. The notes, or T-bills, could have higher rates based on the Fed’s actions.
For Federal loan holders, they can’t do much about changing interest rates, since borrowing rates are determined for loans per academic year. For borrowers of private loans, the T-bill increase and other factors like prime rates could affect how much interest a bank charges. Borrowers will likely pay more with a Fed increase, but it’s unclear how much it will be.
5. Win: Savers
Long-term savings accounts have had interest rate yields at their lowest points in the past five years, compared to rates from 20 years ago. But banks value having more money on hand when borrowing it elsewhere becomes more expensive. Because of that, saving money with certificates of deposit will likely lead to higher interest returns in coming years when the Fed does begin to increase its rate. The average yield on a 1-year CD for March 19, 2015, was 0.27%, according to Bankrate.com’s national weekly survey of interest rates. Some of the best rates on the site are around 1.2%, meaning that for every $1,000 you save for a year, you earn $12. With an increase in the Fed’s interest rate, those earnings are more likely to increase.
6. Win: Investors
For the short term, at least, Wednesday’s announcement from the Fed was good news for investors. Wall Street surged in the afternoon after the Fed seemed to be more cautious about raising interest rates. Overall, an increase in interest rates will likely have adverse affects on the market, at least in the short term. But until the next meeting in April, the Fed’s cautious tone was taken as a sign of goodwill for the Dow Jones industrial Average and Standard & Poor’s 500. The chart above shows the immense rebound the Dow had partway through Wednesday, following the Fed’s decision not to increase rates in March.
The stock market had stumbled in the day or so leading up to the Fed’s announcement, as investors feared the interest rate hikes could be imminent. But the Fed’s projections for a recovering economy weren’t quite as optimistic as in months prior, and projections for GDP growth slowed. Those delayed outlooks of economic progress means the Fed likely won’t institute interest rates at an extremely aggressive rate, and will continue to monitor measures of economic health in coming months before making any changes that could affect the public’s confidence in the economy. “Just because we removed the word ‘patient’ from the statement doesn’t mean we’re going to be impatient,” Janet Yellen, the Fed’s chairwoman, said at a news conference Wednesday. As a result, the Dow and S&P 500 both rose 1.3% and 1.2%, respectively. According to The New York Times, the S&P 500 had been down as much as 11 points prior to the Fed’s 2 p.m. announcement.
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