How the Fed raising interest rates affects your student loans, car payments, and credit cards
For most regular investors who passively dollar cost average (DCA) their way toward retirement, interest rates are like that decorative book on the coffee table that never actually gets read. We’ll give it a glance of respect now and then, but overall, it’s an afterthought.
This isn’t without good reason of course, long-term investors can take great comfort in not having to worry about meticulously analyzing every potential market catalyst that may arise. Guess wha? Interest rates are one of those perpetually relevant numbers.
Nevertheless, ignorance can only be bliss as long as you can dodge its consequences.That’s not the case for the impacts of interest rate hikes. Rate hikes ripple across the financial landscape, and will inevitably find their way into everything from student loans to credit cards, making them entirely relevant to the average consumer.
Some context for where we are now
Although recently you’ve been hearing news about rate hikes and how rates are finally going up, it’s important to note that the numbers we’re seeing now are still historically low in nature. Rates have been trending down since the 1980s—and so have the corresponding inflation issues seen back then.
Nonetheless, rates are still rising, and they kind of had to. Back in 2020, at the onset of the pandemic, the Fed lowered rates to the floor to try and help alleviate a stifled economy and keep everything afloat, hoping to stave off recession.
Although some countries have done it, the U.S. doesn’t seem to be too fond of going the route of sub 0% rates, so there was nowhere to go but up. Additionally, we need higher interest rates in the face of the highest levels of inflation we’ve seen since the 80s.
The skinny on rates and why they matter
So, maybe just calling them “interest rates” is a bit broad; it doesn’t quite tell you the nitty-gritty details, so let’s fix that.
The term “interest rates” or “rate hikes” typically refer to the Federal Funds Rate, which is the target rate that the Federal Open Market Committee (FOMC) sets for allowing commercial banks to lend and borrow their overnight reserves to other banks.
Banks are required by law to maintain a certain reserve to deposits ratio. In short, banks with excess reserves can lend to banks that fall below their required reserve levels, with the lending bank collecting that Federal Funds Rate as interest.
The set rate is strictly a target, not an objective rate. The Fed targets and influences this number by manipulating supply and demand. They do that by buying or selling securities to either add or subtract money from the economy.
Why rates move
The Fed doesn’t raise rates just so banks can pocket a little more revenue. Rates move mostly for macroeconomic reasons—to either stimulate growth or slow down an economy that’s running a little hot (and battling some inflation as a result).
This interest rate is one of our most trusty economic control tools in the belt, and the main cog of monetary policy. The theory is that lower rates = more borrowing, spending, and growth, while higher rates should induce the opposite effect—less spending, and an overall slowdown effect.
The Fed will typically elevate rates in times of inflation to try to curtail its impacts (AKA contractionary monetary policy, or “tightening,” as you may have heard), and lower them in times of economic distress or downturns (AKA easy money policy. (See 1980 for example, or 2020).
Alright, why does this matter?
This interest rate serves as an economic benchmark of sorts, and indirectly influences interest rates on financial products across the industry. As this main interest rate increases, other rates for things like mortgages, credit cards and car loans usually increase, too.
The broader implications: how interest rates affect us
Interest rates have somewhat of a trickle down effect on the overall economy, and no we’re not talking about Reaganomics here. The interest rates from the FOMC will, more often than not, exert some indirect influence on the interest rates you pay on your everyday debt, too.
The Funds rate influences what’s known as the prime rate, which is essentially the base-line rate that commercial banks (and federal lenders) will charge their qualified borrowers on things like personal, student, car, or home loans. You can roughly calculate thisby adding approximately 3% to the Federal Funds rate.
So, with our recent 25 basis point (0.25%) hike, the prime rate has adjusted upward with it. The average rate on a 30-year fixed-rate mortgage has already risen, and although the data isn’t quite in yet, you can expect rates across your car, personal, and student loans to rise, too.
Student loans are perhaps the unicorn of the bunch though, because they’ve been in forbearance for almost two years during the pandemic.
While the rate on federal student loans is fixed, private loans will likely be more vulnerable to the uptick in rates.Federal loans taken out after July 1, 2022 will still be pegged to the 10-year treasury yield plus a margin decided by congress, which is also expected to rise to 4% - 4.5% total, up from the 3.7% (suspended) rate now.
Credit cards won’t escape unscathed either though, with the average APY expected to rise alongside other loan products in the industry as well, likely at rates not seen in years now.
Bringing it all together
The industry expects rates to continue to rise with fairly high certainty, because inflation appears to be a pretty stubborn foe this time around. In times like these, often the best thing to do is simply focus on the variables within your realm of control, and accept that your personal finances are the main priority.
On the flip side, rising interest rates aren’t all gloom and doom!In fact, they usually mean higher yields on savings, and may cause folks to think twice about taking on any new debt.
All-in-all, we’re in this together. You don’t have to navigate these unprecedented, weird economic times and rising interest rates alone, because Pocketnest is here to walk alongside you. We hope you continue to walk with us as well, remembering to log your weekly few minutes and mark off your in-app To-Do List on your path to financial wellness.