How the Fed Rate Hike Affects You
Five Steps to Take Now
The Federal Reserve raised its benchmark fed funds rate to 1.5 percent on December 13, 2017. It expects to raise it twice in 2018, from its current rate to 2.0 percent by the end of the year. It will increase the rate to 2.5 percent in 2019 and to 3 percent in 2020.
That affects all other interest rates. It directly increases rates for savings accounts, CDs, and money market accounts. Banks also use it to guide short-term interest rates. These include auto loans, credit cards, home equity lines of credit and adjustable-rate loans. The Fed's rate increase indirectly affects long-term rates, such as fixed-rate mortgages and student loans. It's one of the most critical factors that determines interest rates.
How It Affects You
The Fed rate hike means banks will pay you a higher interest on your savings. But they will also charge you more for loans.
Savings accounts, CDs, and money markets. Banks base interest rates for all fixed income accounts on the London Interbank Offer Rate. Libor is a few tenths of a point above the fed funds rate. Libor is the rate banks charge each other for short-term loans.
Fixed income accounts include savings accounts, money market funds, and certificates of deposit. Most of these follow the one-month Libor. Longer-term CDs follow longer-term Libor rates. See Libor History Compared to Fed Funds Rate.
Credit card rates. Banks base credit card rates on the prime rate. It's typically three points higher than the fed funds rate. The prime rate is what they charge their best customers for short-term loans. Your credit card interest rate will be eight to 17 points higher than the prime rate. It depends on the type of card you have and your credit score. For more, see Consumer Financial Protection Bureau.
Home equity lines of credit and adjustable rate loans. The fed funds rate directly guides adjustable rate loans. These include home equity lines of credit and any variable rate loans. (Source: "How to Handle Your Finances as the Fed Raises Interest Rates," The New York Times, December 15, 2015.)
Auto and short-term loans. The Fed's rate hikes indirectly affect the fixed interest rates on three- to five- year loans. That because banks don't base these on the prime rate, Libor, or the fed funds rate. They base them on one-, three-, and five-year Treasury bill yields. Yields are the total return investors receive for holding Treasurys. The rate you pay will be about 2.5 percent higher than a Treasury note of the same duration.
The fed funds rate is one of the factors affecting Treasury bill yields. The U.S. Treasury Department sells them at an auction. The higher the demand, the lower the interest rate the government has to pay. That means their interest rates depend on investors sentiment. For example, investors demand more Treasurys when there are global economic crises. Treasurys are ultra-safe because the U.S. government guarantees repayment. As the economy improves, there is less demand. That means the government will have to pay a higher interest rate.
And the Treasury has lots of supply because the U.S. debt is almost $20 trillion.
Another factor is the demand for the dollar from forex traders. When demand for the dollar rises, so does demand for Treasurys. That's because many foreign governments hold Treasurys as a way of investing in the U.S. dollar. They buy them on the secondary market. If the demand for the dollar strengthens, there is a higher demand for Treasurys. That sends the prices up but yields down.
If there is a high demand for the dollar and Treasurys, yields on the Treasury bills could fall. That could offset any increase from the Fed's rate hikes if the demand were high enough. But that's unlikely. As the economy improves, the demand for Treasurys falls. As a result, interest rates on auto and other short-term loans rise along with the fed funds rate.
Mortgage rates and student loans. Banks also base the rates for fixed-interest loans on Treasury yields. Three and five-year auto loans are based on the five-year Treasury note. They base interest rates on 15-year mortgages on the benchmark 10-year Treasury note. The rate for a 15-year fixed rate mortgage is about a point higher than for a Treasury. Again, that extra is so the bank can make a profit and cover costs. As a result, bonds directly affect mortgage interest rates.
Bonds. You may own bonds as part of your IRA or 401-k. Bonds are loans made to corporations and governments. If you own a bond, you make money from the interest rate paid on it. That amount is fixed for the life of the bond. As the fed funds rate rises, interest rates on other bonds will rise to remain competitive. That means bonds will become a better investment in the future. But if you resell your bond, it will be worth less. That's because it offers a lower interest rate than other bonds. For more, see How Do Bonds Affect the Economy?
It's more likely you own bond mutual funds. Higher interest rates don't help bond funds. The Fed only raises rates when the economy is doing well. In that case, most investors buy more stocks. That makes bonds less attractive. That depresses the value of bond funds. For more, see How Do Bonds Affect the Stock Market?
Five Steps to Take Now
1. Pay off any outstanding credit card debt. Your interest rate will go up over the next two years as the Fed raises rates.
2. Feel better about saving. You'll earn more. But don't lock into a three- or five-year CD. As the Fed raises rates rise next year, you'll miss out on the higher returns.
3. If you need to buy appliances, furniture, or even a new car, don't procrastinate. Interest rates on those loans are going up. They will only get higher over the next three years.
The same is true if you need to refinance or buy a new house. Interest rates on adjustable-rate mortgages are going up now. They will continue to do so over the next three years. So question your banker about what happens when the interest rates reset. They will be at a much higher level in three to five years. You may be much better off with a fixed-rate mortgage. That's why now may be the beset time to get a mortgage.
4. Talk to your financial adviser about reducing the amount of bond funds you have. You should always have some bonds to keep a diversified portfolio. They are a good hedge against an economic crisis. But this isn't the right time to add a lot of bond funds. Instead, stocks are a better investment as the Fed continues to raise rates.
5. Pay close attention to the announcements of the Federal Open Market Committee. That's the Federal Reserve committee that raises interest rates. It meets eight times a year. Here's the schedule of 2018 FOMC meetings. Find out How Does the Fed Raise Rates?