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When the Federal Reserve raises interest rates, it means rates on familiar financial products like savings accounts, mortgages and credit cards are likely to rise as well.
Interest rates have been low for so long that many consumers — millennials, particularly — haven’t really known a time when borrowing wasn’t cheap and savings vehicles didn’t pay next to nothing.
Strictly speaking, the Fed can change only a single rate: the federal funds rate. This rate determines how much interest financial institutions charge one another to borrow money overnight. But because so many other rates in the economy are tied to the funds rate, any increase by the Fed has a direct effect on the interest consumers pay when they carry a credit card balance or take out a loan, and on yields for savings accounts and certificates of deposit.
In general, the Fed reduces rates to try to stimulate the economy and raises rates to try to head off inflation.
The Fed slashed the federal funds rate nearly to zero in 2008 to help the American economy ride out the global economic downturn. The rate stayed at rock bottom for seven years. In December 2015, the Fed started raising the rate again.
Here’s what you can expect, and how to position your finances in a rising-rate environment.
Savers and borrowers
In general, higher interest rates are good news for savers and bad news for borrowers.
Savings accounts, in particular, have produced paltry returns in recent years. On average, annual percentage yields have hovered around 0.06% nationwide since 2013, according to the Federal Deposit Insurance Corp. At that rate, you'd earn only $6 for keeping $10,000 in a savings account for a year.
Many savers have squeezed a bit more interest from their accounts by shopping for higher-yield online savings accounts, some of which pay north of 1% — a rate that would not have been considered high at all before the federal funds rate dropped below 1% in 2008.
Certificates of deposit have not fared much better. CDs allow savers to lock in a higher rate by committing to leaving their money untouched for a period of time. But as of June 2016, even a five-year CD was paying only 0.79%, on average.
These historically low rates on savings products won’t jump higher overnight, but a higher federal funds rate can stimulate competition among banks and credit unions, and consumers may benefit from that. It may be worth looking for an account with better rates if your financial institution is slow to respond to a Fed rate increase.
“Savings accounts are so easy to move from bank to bank that it’s almost always worth making sure you’re getting a competitive return on your money,” says Devan Goldstein, a banking analyst at NerdWallet. “Once you’ve got a good emergency fund built up, the difference can be meaningful even in mediocre rate environments.”
Borrowing money in the near future? If rates continue to rise, you will pay a higher interest rate on auto loans and personal loans. Double-check that your existing loans have a fixed interest rate, and consider borrowing sooner rather than later to keep your interest costs down.
Credit card holders
Interest rates on credit cards are typically not fixed, so they’re especially vulnerable to changes in the federal funds rate. If you’re carrying credit card debt, you can probably expect your interest rate — and also your minimum payment — to rise. That will make it harder to chip away at the debt.
But there are moves you can make to take the sting out of climbing credit card interest.
Reducing your credit card debt aggressively is a good idea no matter what rates do. Re-evaluate your budget to see if you can free up any cash to pay down your credit card balances, and think about whether you can increase your income, even temporarily.
As interest rates rise, make sure you’re making at least the minimum payments on time, on every card. This will help strengthen your credit score over time, which will make it easier to qualify for lower-interest loans.
If you do have good credit, consider moving higher-interest debt to a 0% balance transfer credit card. These offers may become scarcer if the Fed continues to raise interest rates, and locking down a 0% APR for 12 months or more is a great way to make a significant dent in your debt. Paying down your balances will also improve your credit score.
If you own a home, you may be able to borrow equity to pay off your credit cards. But be careful — home equity lines of credit, which often have variable interest rates, are also likely to be affected by the Fed’s rate hike. Consider instead a fixed-rate home equity loan, or refinance your primary mortgage to pay off your credit card debt and lock in a low fixed rate now while you still can.
Homeowners and homebuyers
A hike in the federal funds rate will steer mortgage rates higher, but it’s likely to take some time before there is a significant increase in 30-year home loan interest rates.
The Fed’s rate increase ended what has been effectively a zero-interest-rate environment, because the federal funds rate has been so close to zero for so long. The rate hike will likely mark the end to historically low mortgage rates, although the rise in such rates is expected to take time to get started and be slow once it gets underway.
However, if the Fed continues to boost short-term rates over the next two to three years — and inflation climbs — homebuyers will see mortgage rates rise significantly.
It’s important to consider that even incremental rate increases, as this one was and as future rate hikes are likely to be, are costly when imposed on big-ticket items like homes and stretched out over the life of a multiyear loan.
For instance, a 30-year mortgage at a rate of 4% on a $300,000 loan yields a monthly payment of about $1,400. A rate of 6% bumps that to $1,800 — and adds more than $130,000 in interest over the life of the loan. When higher rates are combined with rising home prices, it’s easier to get priced out of the market, especially for first-time buyers.
Getting ahead of the tide of rising interest rates can save borrowers thousands of dollars. Consumers with adjustable-rate mortgages and home equity lines of credit should take a close look now at their financing options, and consider moving to currently low fixed-rate alternatives.
Investors have had nearly a decade to get used to a falling interest rate environment, so fear that the Federal Reserve’s rate hike will shake things up is natural. But there’s plenty of precedence, as recently as 2004, that indicates the market response to a rise in rates tends to be moderate, if not favorable over the long term.
This particular rate increase has two advantages: It was highly anticipated, which means that in many respects, it has already been baked into the market. And it’s the result of a strengthening economy and a growing job market, which is nothing but good news for investors going forward.
That means as with any other potential market turbulence, the best response to this rise in rates is no response at all. Investing, especially for retirement, is a long game, and volatility is to be expected. Investors who are able to ride out those fluctuations do best. Recent analysis from financial technology company CircleBlack shows that even someone who started investing in U.S. stocks in 1929 — yes, the beginning of the Great Depression — would’ve bounced back and experienced growth within seven years.
The lesson: Rather than constantly monitoring your brokerage account balance, stick to a strategy of buying into the market on a regular basis. You’ll buy on sale when the market is down, and capture gains when it inevitably rides back up.
Following the Fed’s move, small-business loans may cost more in interest — but only with lenders whose rates are heavily influenced by the Fed.
For example, SmartBiz originates small-business loans guaranteed in part by the U.S. Small Business Administration. Its rates are based on prime rate, a widely used benchmark that’s pegged to the federal funds rate. If the prime rate goes up by 0.25%, that means the interest rate on SmartBiz loans will rise by the same amount. The difference can be significant for a small, privately held company that needs to borrow money in order to grow.
Rising rates likely won’t have a big impact at online lenders that don’t use the prime rate to set rates, such as Funding Circle, OnDeck, Prosper and Kabbage. Some businesses may be able to avoid getting hit with a higher rate by seeking out one of those lenders.
But rising rates will mean higher costs on existing variable-rate debt, such as business credit cards and adjustable-rate mortgages. Just like individual consumers, small businesses may want to look for ways to reduce debt and refinance adjustable-rate loans into something with a fixed interest rate.
For adjustable-rate mortgages, for example, small-business owners should figure out when the loan’s interest rate is due to reset, and how it will affect payments on the loan. Refinancing to a fixed-rate mortgage before rates rise could make sense, but only if the expected savings outweigh the costs of refinancing.
A rising rate environment
After the first rate hike, the Fed will be watching to see how the move affects the economy. If the job market and other financial indicators remain strong, you can expect rates to keep inching higher.
This initial bump is an opportunity to prepare yourself for a possible trend toward higher rates. Reducing debt, especially when you’re paying a variable interest rate, will help you get ready for a rising-rate environment. So will increasing your savings and staying focused on your long-term investing strategy, in spite of day-to-day fluctuations in the stock market.
If you manage your money carefully and the economy stays strong, rising rates will be a good thing for your wallet.
Infographic by Jazeena Pineda.