Federal Reserve Rate Hike Winners and Losers
The Federal Reserve began raising interest rates on December 15, 2015. It plans to maintain rates at current levels through 2021. In this stable rate environment, there will be some winners and some losers.
The Federal Open Market Committee last raised the fed funds rate by a quarter point at its December 19, 2018, meeting. The current fed funds rate is 2.5 percent. The Committee is does not see enough economic growth and inflation to warrant further hikes. As a result, it will not increase this interest rate for the next few years.
How do these stable interest rates affect you? It depends on whether you are a saver or a borrower. An increasing fed funds rate improves returns on savings accounts, money market accounts, and certificates of deposit.
Loans are a little different. Only adjustable-rate loan interest rates are determined by the fed funds rate. These include auto loans, adjustable-rate mortgages, and credit cards.
On the other hand, rates on long-term loans and mortgages follow the 10-year Treasury yield. As the economy improves, demand for Treasurys falls. Investors are willing to put their money into riskier stocks and bonds to get higher returns. As a result, Treasury yields rise to attract more buyers. Higher Treasury yields drive up interest rates on long-term loans, mortgages, and bonds.
Savings Accounts and CDs
In the current stable rate environment, holders of savings accounts and certificates of deposit lose. Those interest rates track the London Interbank Offer Rate. That's the rate banks charge each other for short-term loans. Libor is usually a few tenths of a point above the fed funds rate. Savings accounts follow the one-month Libor rate, while CDs follow longer-term rates.
It's more important than ever to find the best savings account interest rates. Small banks and credit unions can offer higher rates because they have lower costs. Even if they don't have physical banks in your area, you can do all your banking online.
Since rates aren't going up, you may as well lock your money into a CD that is longer than six months if it pays more. You're not going to miss out on any future rate hike increases.
Money market funds offer slightly higher rates than savings accounts or CDs. They invest in the money market instruments offered only to businesses. They also invest in U.S. Treasurys and CDs. They are very safe most of the time. The only time they weren't was during the financial crisis. Businesses began pulling out their funds, forcing the federal government to step in and guarantee them. The best money market rates require a minimum deposit.
Those who have large outstanding balances on their credit cards will gain from the stable interest rates. Banks base their credit card rates on the prime rate. It's what they charge their best customers for short-term loans. It's three percentage points higher than the fed funds rate.
Banks can charge anywhere from 8 percent to 17 percent more than the prime rate for credit card rates. Those with good credit scores pay the lower rates, while those with poor scores pay the higher rates. Banks also charge different rates depending on the type of card.
Even in a stable rate environment, the best way to become a winner is to pay off outstanding credit card debt. Once that's done, only charge what you can afford to pay off each month. You can also transfer that debt to a zero-interest credit card for a small fee.
Adjustable Rate Loans
The fed funds rate guides adjustable rate loans. These include home equity lines of credit, interest-only mortgages and any other variable rate loans. Interest on your outstanding loan balance should stay the same unless it resets. Check your documents to see if the rate increases after the first two years.
Everyone can win on these loans if they pay them off early. Just make sure there is no penalty for early repayment.
Most auto loans are from three to five years with fixed interest rates. Any holder of a fixed rate loan is a winner. Those rates don't follow the prime rate, Libor, or the fed funds rate. Instead, they are about 2.5 points higher than one, three, and five-year Treasury bill yields. Yields are the total return investors receive for holding the bills.
The U.S. Treasury sells Treasury bills, notes, and bonds at an auction for a fixed interest rate. Investors can sell them on the secondary market. Many other factors influence their yields. These include the demand for the dollar from forex traders. When demand for the dollar rises, so does demand for Treasurys. Investors will pay more to buy them. Since the interest rate doesn't change, the overall yield falls.
Demand for Treasurys also increases when there are global economic crises. The U.S. government guarantees repayment. As a result, interest rates on long-term debt only loosely follow the fed funds rate.
Mortgage Rates and Student Loans
Banks set fixed rates on conventional mortgages a little higher than the yields on 10, 15, and 30-year Treasurys. Interest rates on long-term loans rise along with those yields. The same holds true for student loans. Mortgage interest rates have a tight relationship to Treasury note yields. As a result, all fixed-rate mortgage and student loan holders are winners.