Since the economic downturn of 2008/2009, a point of contention between the powers that be and consumers has been the timeline for increasing interest rates. The Federal Reserve, more commonly referred to simply as the Fed, uses its authority to reduce or raise interest rates to prompt economic shifts. The recession forced interest rates down to historically low levels, and they have stayed there amid widespread uncertainty surrounding the U.S. economy’s stability. Now, as economic trends show relatively steady upward movement, the Fed hints at an increase in interest rates in an effort to bolster and sustain positive economic activity.
While an increase in interest rates has positive implications for consumers setting money aside in conventional savings and investments, the Fed’s next move could have a drastic impact on individuals planning to borrow money. Let’s take a look at how a rising interest rate environment could affect your personal financial circumstances.
The Mortgage Environment
For most consumers, the ability to purchase a home is only viable when affordable financing through a mortgage is available. While interest rates remain at low levels, the cost of borrowing from a financial institution by way of a mortgage remains relatively low as well. As the interest rate market shifts upward, both current and prospective borrowers have the potential to be hit hard.
Increasing interest rates affect homeowners with adjustable rate mortgages the most. With an adjustable rate mortgage, borrowers are at the mercy of broad interest rate markets as spelled out in their initial loan agreement. After a certain period of time, typically three, five, or seven years, adjustable rate mortgages adjust based on the underlying interest rate index to which they are linked. Should the Fed increase interest rates, homeowners with adjustable rate mortgages are likely to see the cost of their loan and their monthly payment increase.
For prospective homebuyers, an increase in the interest rate market could price them out of their new home. As an example, a $200,000 mortgage with an interest rate of 3.5% carries a monthly principal and interest payment of $898; increasing the interest rate to 5.5% on the same mortgage results in a principal and interest payment of $1,135 each month. That $237 difference could be too much for some borrowers to manage, putting their dream of home ownership out of reach. While an interest rate hike is unlikely to be a full 2% overnight, an increase of that magnitude could take place over the course of a year or two, creating a difficult situation for current and prospective homeowners alike.
Impact on Student Loans
Rising interest rates also have the potential to impact personal finances by way of student loan costs and repayment. For borrowers with federal student loans already funded, interest rates are fixed for the life of the loan, ranging between 3.76% and 7.21% depending on when the loan proceeds were received. Similarly, borrowers with Perkins loans enjoy a fixed rate of 5% regardless of when the loan was funded. However, because student loan interest rates are adjusted annually based on the broad interest rate market, students looking to borrow in the upcoming years may be paying more to fund their education.
An increase in interest rates will impact far more borrowers with student loans funded through private lenders, especially if those loans are tied to a variable rate. Privately funded loans, either through banks, credit unions, or online lenders, often entice borrowers by offering a lower initial interest rate than federally funded student loans. Unfortunately, the rates are often variable, meaning they can and will fluctuate as the Fed makes changes to interest rate policy. If you have a variable interest rate student loan, you can expect the total cost of your loan to increase as well as your monthly payment as interest rates rise.
Credit Card Users
Similar to privately funded student loans, nearly all credit cards carry a variable interest rate. As interest rates rise, the cost of carrying debt on a credit card also increases. Regulations have set caps on how much credit card companies can increase interest rates over time, but credit card users should understand those limits fully. If you carry a credit card balance over from month to month, rising interest rates may force you to pay off the outstanding debt or transfer a balance to a 0% card.
Personal loans, car loans, and home equity loans all stand to shift in line with an interest rate increase as well. While home equity loans represent an affordable way to tap into the accumulated equity in a real estate property, rising interest rates may create a situation where that is no longer a viable solution. Taking out a personal loan becomes more expensive as well, reducing the gap between refinancing credit card debt, the most common borrowing reason, and high-interest-rate credit cards. Likewise, financing a new or used car becomes less affordable when interest rates move upward. Overall, the cost of borrowing in any capacity increases drastically when the Fed makes the decision to increase interest rates.
Not all is Lost
Although an environment in which interest rates are rising paints a rather gloomy picture for borrowers, an opportunity lies in wait for those willing to set money aside for the future. As financial institutions are able to collect more earnings on lending products via higher interest rates, that additional revenue is passed down to account holders via higher interest rates on certain accounts. Savings, money market, certificates of deposit, and checking accounts all stand to earn more than the dismal interest accumulated during low-interest rate markets, helping savers enhance their overall financial picture for the long term.
In addition to the added boost to savings vehicles, rising interest rates point to a much broader benefit relating to your personal finances. The Fed makes the difficult decision to raise interest rates when the economy is strong and stable; this means that the jobs market, housing market, and stock market all show signs of growth in the present and near future. These factors add up to a better overall financial environment for individuals across the board.
Although a rising interest rate does not sit well among most borrowers, steps can be taken to reduce the blow. Refinancing your mortgage or student loans into a fixed-rate loan is a smart option for those who qualify. Similarly, working to pay off debt balances prior to an interest rate hike is a smart move for those who spend heavily on credit cards. Understanding the implications of a rising interest rate environment is the first step in making the inevitable change work best for your personal financial circumstances; taking action to safeguard yourself from a higher cost of borrowing is a close second.