What a Fed Rate Hike Means for Borrowers, Savers and Home Buyers
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Action items when interest rates are rising:
Shop for a higher-yielding online savings account to take advantage of higher rates.
Pay down your credit card debt; consider a balance transfer credit card.
If you're shopping for a home, make sure your mortgage preapproval reflects current interest rates.
After raising interest rates seven times last year, the Federal Reserve announced its first hike of 2023, increasing rates by a quarter of a percentage point on Feb 1.
That means rates on familiar financial products like savings accounts, mortgages and credit cards may rise. Interest rates have been low for so long that many consumers — millennials and Gen Z, 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. Here’s what you can expect, and how to position your finances in a rising-rate environment.
Higher returns for savers
In general, higher interest rates are good news for savers and bad news for borrowers.
Interest rates on some savings accounts, in particular, have increased nearly tenfold over the past year. A year ago, even the best rates were hovering around 0.50% annual percentage yield, but the best rates have increased, with a few topping 4% APY now. Certificates of deposit have seen exceptionally high rates. Many savers can benefit considerably by shopping for higher-yield online savings accounts and high-yield CDs, which tend to offer better returns than traditional bank accounts.
The 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. Rates at some of the largest national banks are still paltry, with next-to-zero APYs, so it may be worth looking for a savings account with better rates, especially at an online bank or online credit union, if your financial institution is slow to respond to a Fed rate increase. The best high-yield savings accounts tend to be among the first to raise their yields after a federal funds rate increase.
More expensive debt
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 whether 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, ensure 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 balance transfer credit card. These offers may become scarcer if the Fed continues to raise interest rates, and locking down a 0% intro 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 plan to borrow money in the near future, you can expect to see higher interest rates 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.
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 Fed rate hikes. But if you want to use some of your equity without changing the interest rate on your primary mortgage, a HELOC or a home equity loan may be your best bet. For homeowners who bought or refinanced while rates were at historic lows, a cash-out refinance that comes with a significantly higher interest rate just doesn't make sense.
Impact on home buyers
Mortgage rates went up ahead of each Fed rate hike in 2022. But they fell in January, during the lead-up to this Fed increase, because inflation has been cooling off.
The Fed exerts influence on mortgage rates, but indirectly. So far this year, mortgage rates have responded to changes in inflation. With the inflation rate falling, mortgage rates have fallen, too.
This year's home buyers still face headwinds, because mortgage rates are higher than they were at the beginning of 2022. That means homes are less affordable than a year ago. For instance, a 30-year mortgage at a rate of 3% — which was pretty normal in 2020 and 2021 — on a $350,000 home with a 20% down payment yields a monthly principal-and-interest payment of about $1,180.
However, a rate of 6.25% bumps that to $1,724. When higher rates are combined with rising home prices, it’s easier to get priced out of the market, especially for first-time buyers.
Given how much interest rates can change the math of your homebuying budget, make sure to keep your mortgage preapproval up to date. You don't want to make an offer on a home only to find out that it's out of your price range at the current interest rate. You might also consider buying a mortgage rate lock to ensure your rate doesn't increase before your home purchase closes.
A rising rate environment
Reducing debt, especially when you’re paying a variable interest rate, will help you in 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.