The Federal Reserve laid the groundwork for interest rate hikes Wednesday.
At the conclusion of its two-day meeting, the central bank said it will aggressively unwind last year’s bond buying after a variety of inflation reports reached their highest levels in decades.
Although interest rates will stay near zero for now, Fed officials set the stage for the first of multiple rate hikes starting as soon as March as they look to contain soaring inflation.
“The Fed got the memo,” said Greg McBride, chief financial analyst at Bankrate.com.
How the federal funds rate affects you
The federal funds rate, which is set by the central bank, is the interest rate at which banks borrow and lend to one another overnight. Although that’s not the rate that consumers pay, the Fed’s moves still affect the borrowing and saving rates they see every day.
Now that the central bank’s easy money policies are about to end, consumers will have pay more to borrow and still barely benefit from better rates on their deposits.
Further, the first rate hike will be just the beginning, McBride noted. “The last time the Fed raised rates, it raised rates nine times in a three-year period.”
“The cumulative effect of rate hikes is what is really going to have an impact on the economy and household budgets,” he added.
The cost of borrowing will rise
As the Fed unwinds its bond purchases, long-term fixed mortgage rates are edging higher, since they are influenced by the economy and inflation.
The average 30-year fixed-rate home mortgage has already risen to 3.75%, and is likely to climb to 4% by the end of 2022, according to Jacob Channel, senior economic analyst at LendingTree.
The same $300,000, 30-year, fixed-rate mortgage would cost you about $1,389 a month at 3.75%, while it would cost $1,432 at a 4% rate. That’s a difference of $43 a month, or $516 a year, and $15,480 over the lifetime of the loan, according to LendingTree.
If rates rise to 4.5% then you would pay $131 a month more or another $1,572 each year, and $47,160 over the loan’s lifetime.
As rates rise, there are fewer opportunities to refinance, although borrowers with a good credit score can still find annual percentage rates around 3.25% for a 30-year, fixed-rate refinance loan, and 2.62% for a 15-year, fixed-rate loan, according to Lending Tree.
“Waiting has cost you big time,” Bankrate’s McBride said. “If you are paying a rate over 4%, you can still benefit but it’s going to be more modest.”
“Buyers who are worried about how rising rates will impact them should work on boosting their credit score and saving up as much cash as possible before they apply for a loan,” Channel said.
“The more money that they can put toward a down payment and the higher their credit score is, the better the rate they’re likely to be offered.”
And “even though they’re rising, today’s mortgage rates are still relatively low from a historical perspective,” he added.
Shorter-term borrowing rates, particularly on credit cards, will head higher even faster.
Since most credit cards have a variable rate, there’s a direct connection to the Fed’s benchmark, so expect your APR to rise when the Fed makes a move. Credit card rates are currently around 16.3%, down from a high of 17.85%, according to Bankrate.
“A small increase or two spread out over several months isn’t going to rock most people’s financial worlds,” said Matt Schulz, chief credit analyst for LendingTree.
If you owe $5,000 on a credit card with an APR of 19% and put $250 a month towards the balance, it will take 25 months to pay it down and cost you $1,060 in interest charges. If the APR edges up to 20%, you’ll pay an extra $73 in interest.
However, “several small rate hikes begin to add up,” Schulz said, and “for folks with a lot of debt, any increase in interest is unwelcome. That’s why people need to take action today.”
Borrowers could call their card issuer and ask for a lower rate, switch to a zero-interest balance transfer credit card or consolidate and pay off high-interest credit cards with a home equity loan or personal loan, Schulz advised.
Cards offering 15, 18 and even 21 months with no interest on transferred balances are “one of the best weapons in the battle against card debt,” Schulz said.
Savers get squeezed
When the Fed does raise it benchmark rate, deposit rates will be much slower to respond, and even then, only incrementally.
While the Fed has no direct influence on deposit rates; they tend to be correlated to changes in the target federal funds rate. As a result, the savings account rate at some of the largest retail banks has been hovering near rock bottom, currently a mere 0.06%, on average.
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“Many banks are not going to be passing along higher rates to savers, so where you have your money parked is going to be really important,” McBride said.
Thanks, in part, to lower overhead expenses, the average online savings account rate is at least three times higher than the average rate from a traditional, brick-and-mortar bank.
If you have $10,000 in a regular savings account, earning 0.06%, you’ll make just $6 in interest in a year. In an average online savings account paying 0.46%, you could earn $46, while a five-year CD could pay nearly twice as much, according DepositAccounts.com.
However, because the inflation rate is now higher than all of these rates, any money in savings loses purchasing power over time.
Look for other options with better rates, advised Yiming Ma, an assistant finance professor at Columbia University Business School, such as money market funds, bond mutual funds or bond ETFs.
There are alternatives out there that will require taking on more risk but come with increasing returns, she said — as long as you are somewhat shielded from recent market volatility.
“Set aside enough cash to cover every day expenses, so you are protected against the big ups and downs,” Ma said. “The rest can be invested in something that can get a good long-term return.”