Interest rates increases have been a hot topic in 2015 and will likely continue into 2016. The Federal Reserve is closely evaluating the economy looking for signs that it is time to start raising rates for the first time in 6 years. At each meeting, discussions are made about when and how much rates should begin to go up. The last meeting of the year will take place in December and analysts are expecting the rates to increase at this time. With the economy at nearly full employment and the recession officially behind us, it seems the conditions are ripe for rising rates to begin to take hold.
We have enjoyed the lowest rates in decades, and as that comes to an end, making the right decisions regarding debt management can prevent you from encountering a personal recession. It is anticipated that rates will increased slowly over the next few years to keep inflation under control, without dipping the economy back into another recession.
Why Interest Rates Impact Economic Growth
The Federal Funds rate is the rate banks charge each other for overnight funds. This is the rate the Federal reserve controls. All other rates work in conjunction with this index. When the Federal funds rate increases, Prime Rate (the consumer indexed rate that banks offer to their best customers) goes up in a direct ratio. If the Federal Funds rate increases by 0.25%, the Prime Rate will also increase by 0.25% the following month.
Long term rates like Treasuries and mortgages adjust based on supply and demand. Both go in the same direction as the Federal Funds rate.
One key reason the Federal Reserve monitors and adjusts interest rates is to control inflation. When inflation rises, increasing interest rates put pressure on inflation to keep prices in check. Inflation is defined as the cost of goods rising over time. For example: if a gallon of milk today costs more today than it did a year ago, inflation has occurred.
Who Benefits from Rising Rates
The clear winner of increased rates are conservative investors who want to place money in secure funds like CD’s and US Treasuries. Those seeking to purchase new bonds will also benefit from higher interest rates, as they will be able to buy bonds that pay more.
Import companies receive better value on imports and this can increase sales for imported goods, because the dollar strengthens as interest rates rise. A strong dollar can also be beneficial for those who live or travel overseas and receive income in US currency.
Who Suffers from Rising Interest Rates
Businesses borrowing money, consumers taking on new debt, and consumers with existing debt will pay more for the use of other people’s money, as interests rates increase.
Businesses borrowing money will pay more for new loans. In the case of large corporations who issue bonds as debt, they will have higher debt payments in the form of higher bond rates. Consumers who buy these bonds are the winners because they gain a higher interest rate while the relative risk remains the same. Other ways businesses take on debt is through loans. These loans will now be issued at higher rates which can raise the costs of goods and result in cost cutting measures by the business.
Consumers taking on new debt will pay more for new loans reducing discretionary income. Rates will rise on both fixed and variable rate loans and large volume loans like a mortgage can significantly impact buying power.
Here is an example of a $100,000, 30-year mortgage loan and the impact of rising interest rates on the monthly payment.
|Interest Rate||Monthly Payment||Annual Payments||Total Interest Paid Over 30 Years|
When banks evaluate whether to approve a loan, they consider the new monthly payment added to current debt, compared to the current income. This determines the amount of loan you are able to qualify for. You can see that an increase in payments of $712.80 per year for a one-point interest rate difference will impact the amount you are able to borrow. Buying a $200,000 home would result in an increase of $1,425.60 a year or $118.80 cents a month. A $400,000 home would be double that. This represents lower buying power. You will either qualify for a smaller loan amount or be required to put a larger down payment down in order to purchase the home.
Consumers with existing variable debt could see a decline in disposable income almost immediately. Credit card debt is a major culprit as minimum payments will rise as interest rates rise. These rates are generally variable and are tied to Prime. They typically increase in less than 30 days from the time rates go up. Higher interest rates that compound monthly will have compounded results from those seen above. Home equity lines of credit will also see an immediate increase in rate, while variable rate mortgages will not re-set until the anniversary of the loan.
Plan of Attack, What You Can Do:
With increasing interest rates a matter of time, now is the opportunity to take a close look at your current debt situation. Consider lending needs over the next few years. Home purchases, refinancing a mortgage or taking out a car loan would benefit from immediate action to lock in on the lowest rates seen in decades. For those with current variable rate debt consider your options for locking in those rates.
Student loans might be able to be consolidated into a single fixed rate loan. If you are finished with school, this will also result in a single payment for a single loan which will be easier to track.
Credit cards rates might be able to be negotiated by calling the card provider. If you are current with payments and have had no late payments in the last 12 months, you may qualify for a lower rate just by asking. A rate reduction will reduce the spread, which will still result in a rate increase when Prime rises, but will lessen the impact. Consolidation loans into fixed rate products may also be a viable option if you are able to qualify.
Mortgages that have variable rates might be able to be refinanced if you can get approved. Current mortgage holders sometimes offer streamlined refinances that minimize costs and paperwork. The mortgage company does not want you to be priced out of your mortgage and might have options even if you have high credit card debt.
If you are currently struggling to make minimum payments now, a rise in interest rates could become the straw that breaks the camel’s back. Finding solutions before rates rise could stave off a financial crisis around the corner.
Credit counselors and debt relief providers like Timberline Financial can review your current debt situation and offer practical solutions that will enable you to get debt under control before costs rise beyond your ability to maintain.