Back in 2009, the U.S. Federal Reserve (the Fed) lowered its benchmark interest rate almost to zero in an effort to entice people to spend and bolster the economy in the aftermath of the financial crisis. Since then, the economy has seen little change in interest rates as they have remained at historic lows.
But interest rates will rise again, as they always do—and when that happens, how will those higher rates affect your personal finances? When you hear of the possibility of rate hikes by the Federal Reserve, you can take several proactive measures to minimize the effect on your financial situation.
How Rising Interest Rates Affect the Economy
When the Fed starts pushing up interest rates, you'll see the effects flow through to your credit card debt, mortgage rates, and rates on car loans. The average U.S. household debt, according to the Fed, is $20,000, not including mortgages. Most of that debt is credit card debt and home equity lines of credit, and people with this type of debt are affected the most by rising interest rates.
If you're struggling to pay your credit card bills each month or you pay your bills but can only swing the minimum payment, even a small rise in interest rates could create a problem. As the rates gradually rise, more of your monthly payment will go toward interest and less toward paying off the principal portion of your balances. What can you do?
Pay Down Your Credit Card Debt
If you're only making minimum payments on your credit cards, start paying more. If you can't come up with the money to increase your payments, start budgeting or tighten your existing budget, cut spending, and pay down credit card debt with the money you save. For help with budgeting, learn some budgeting basics.
Additionally, if you have money sitting in low-interest savings accounts, using that money to reduce your credit card debt and avoid higher interest gives you, in a way, immediate return on your money.
Protect Your Invested Cash
When interest rates start heading up, you can take advantage of the increase by putting your money into certificates of deposit (CDs). However, as rates continue to climb, you don't want to have your cash locked up, for example, in a five-year CD with a lower rate. In an economy characterized by rising interest rates, consider using the "laddering" technique, which involves buying CDs with varying terms. This gives you the chance to reinvest the funds at higher rates as the CDs mature.
You might also find promotional rates on savings accounts that look attractive, but check the expiration date; these types of offers are typically good only for a set period of time. Whether you choose to put your cash into CDs or a savings account, make sure it's insured by the Federal Deposit Insurance Corporation (FDIC) for banks or the National Credit Union Administration (NCUA) for credit unions.
Regardless of whether a certain investment vehicle is paying a great interest rate, resist the temptation to put all of your money into one basket. Your best bet is to diversify and consider a variety of investments such as real estate, stocks, bonds, and commodities.
Don't Be Fooled by "Fixed Rate" Credit Cards
Your credit card company legally only needs to give you 15 days written notice before raising your rate. Even so, if interest rates are expected to increase and you haven't already transferred your balances to lower-rate cards, you should consider doing so, looking for those that promise a low rate for a specific period of time.
Keep your eyes out for zero percent interest offers for balance transfers, but keep an eye on the expiration date and pay the balance off well in advance. For advice on the fastest way to reduce your credit card debt, find out how to get out of debt now.
Consider a Home Equity Loan Over a Line of Credit
If you have a home equity line of credit, consider taking out a home equity loan to repay it if interest rates are expected to rise. Since interest rates on home equity lines of credit are tied to the prime rate, if rates rise, so will the interest on your line of credit.
Depending on how much you borrowed, this payment could quickly become one you can't afford, and your house is at risk. By replacing the home equity line of credit with a home equity loan, you lock in a lower interest rate. When it comes to home equity loans, look before you leap.
If you already have a home equity line of credit, consider paying it off with savings, especially if that money isn't earning much interest. As interest rates rise, your line of credit could start costing you quite a bit more in monthly interest payments.
Choose a Fixed-Rate Mortgage Over an ARM
If you have an adjustable-rate mortgage (ARM) and you plan to be in your home for at least five years, consider refinancing to a fixed-rate mortgage when rates are expected to rise. You should also know how to take advantage of lower mortgage interest rates.
Buy a House Sooner Rather Than Later
As mortgage interest rates rise, you'll be able to afford less house for your money. If rates are expected to rise and you're in the market for a house, consider stepping up your house-hunting efforts. Be sure to research real estate trends in your area so that you don't buy at a period of inflated home prices.
Buy a Car Sooner Rather Than Later
Similar to buying a house, if you're in the market for a new car, consider accelerating your plans before interest rates rise, possibly taking advantage of zero percent financing. These offers often disappear as rates rise. Also look into other ways to save money on your next car.