Rising interest rates increase the cost of credit cards, loans, and mortgages. They also improve the interest you can earn on savings accounts and certificates of deposit (CDs).
Interest rates stopped rising in 2019. As of June 2021, the Fed doesn't plan to increase them again until after 2023. At the Federal Open Market Committee (FOMC) meeting in July 2021, the Fed confirmed that it would maintain its target for the fed funds rate at a range of 0% to 0.25%.
This plan won't impact savings accounts, mortgages, CDs, and credit cards all in the same way. Each product relies on a different benchmark. As a result, increases for each depend on how their interest rates are determined. Here's what you need to know about interest rates, when the Fed will raise them, and how your finances will be affected.
The two most important determinants of interest rates are the fed funds rate for short-term loans and the 10-year Treasury yield for long-term loans.
When Will the Fed Raise Interest Rates?
On July 28, 2021, the Federal Open Market Committee (FOMC) announced that it wouldn't raise the fed funds rate. As it had in June 2021, it said it wouldn't do that until inflation remains at or above 2%. The FOMC is the monetary policy arm of the Federal Reserve System. At its June meeting, it forecast that inflation won't reach that level until after 2023.
The current fed funds rate target range is 0% to 0.25%. The FOMC lowered it to that level on March 15, 2020, to support the economy during the COVID-19 pandemic. The last time it lowered the rate to this level was in December 2008. It stayed there until December 2015.
On March 9, 2020, the 10-year Treasury yield fell to a record low of 0.54%. Investors were panicked because of the COVID-19 pandemic. As of July 28, 2021, the rate had risen to 1.26%. Demand for ultra-safe Treasuries will remain high during the pandemic.
The Fed also influences Treasury yields. Through its quantitative easing (QE) program, the central bank purchases Treasuries to keep the yield low.
On March 23, 2020, the FOMC expanded QE purchases to an unlimited amount. As a result, its balance sheet almost doubled in a few months to more than $7 trillion.
Once the economy improves, demand for Treasuries will fall. The yields rise as sellers try to make the bonds more attractive. Higher Treasury yields drive up interest rates on long-term loans, mortgages, and bonds.
How High Can Rates Go?
The Fed doesn't plan on raising the fed funds rate until after 2023, or until the economy improves. Historically, the benchmark rate has had a sweet spot of 2% to 5%. The highest it's ever been was 20% in 1980 and 1981. The Fed raised it to combat an inflation rate of 13.5%. It also battled stagflation—the unusual circumstance caused by wage-price controls, stop-go monetary policy, and taking the dollar off of the gold standard. The yield on the 10-year Treasury note also hit a record high in 1981—it was 15.84% on September 30, 1981.
Long-term rates could rise higher at any time since, they are bought and sold on the secondary market. Although they could, it's unlikely that they will rise, since the Fed is buying enough through QE to keep rates low.
All short-term interest rates follow the fed funds rate. The fed funds rate is the interest rate banks charge each other for overnight loans. While banks set this rate themselves, it rarely varies from the Fed's target rate. Banks know that the Fed can use open market operations to pressure them to meet the target. Short-term rates affect the interest rates on savings accounts, CDs, credit cards, and adjustable-rate loans.
Savings Accounts and CDs
Interest rates for savings accounts and certificates of deposit track the London Interbank Offer Rate (LIBOR). That's the interest rate at which major international banks are willing to offer eurodollar deposits to one another. The Libor rate rarely diverges from the fed funds rate. Banks may pay you a little less than Libor so they can make a profit. Savings accounts may follow the one-month Libor rate, while CDs may follow longer-term rates. Libor will be phased out sometime after 2021.
Credit Card Rates
Banks base credit card rates on the prime rate, which is what they charge their best customers for short-term loans, typically 3 percentage points higher than the fed funds rate. Banks can charge anywhere from 8% to 17% more for credit card rates, depending on your credit score and the type of card. It's always a good idea to pay off any outstanding credit card balances due to the high rates.
Home Equity Lines of Credit and Adjustable Rate Loans
The fed funds rate guides adjustable-rate loans. These include home equity lines of credit and mortgages. As the fed funds rate rises, so will the cost of these loans. Pay them down as much as you can to avoid any surprises. As 2021 rates are low, talk to your bank about switching to a fixed-rate loan to protect yourself from future rate increases.
Long-term rates follow the 10-year Treasury yield. The U.S. Treasury sells Treasury bills, notes, and bonds at an auction for a fixed interest rate that loosely tracks the fed funds rate. Investors can then sell them on the secondary market.
Many factors influence their yields. These include the demand for the dollar from forex traders. When demand for the dollar rises, so does the demand for Treasuries. Investors will pay more to buy them. Since the interest rate doesn't change, the overall yield falls.
Demand for Treasuries also increases when there are global economic crises. That's because the U.S. government guarantees repayment. All of these factors mean that interest rates on long-term debt aren't as easy to predict as those based on the fed funds rate.
Auto and Short-Term Loans
Fixed interest rates on three- to five-year loans don't follow the prime rate, Libor, or the fed funds rate. Instead, they are a few percentage points higher than one, three, and five-year Treasury bill yields. Yields are the total return that investors receive for holding the bills.
When rates do rise again, it will be best to keep your fixed-rate loans. Rising interest rates won't affect them.
Mortgage Rates and Student Loans
Banks set fixed rates on conventional mortgages a little higher than the yields on 10-year, 15-year, and 30-year Treasury bonds. Interest rates on long-term loans rise along with those yields. The same holds true for student loans. Mortgage interest rates closely follow Treasury note yields.
If you're thinking of refinancing, now may be the time to lock in a lower fixed rate. For new homebuyers, be wary of an adjustable-rate mortgage just to afford a bigger house. It may be better to get a fixed-rate loan to protect yourself from future rate increases.
State, municipal, and corporate bonds compete with U.S. Treasuries for investors' dollars. As they are riskier than U.S. government bonds, they must pay higher interest rates than Treasuries. That's true for all other types of bonds.
Fitch, Moody's Investors Service, and Standard & Poor's are the main agencies that rate the risk of default. Bonds with the most risk, called "high-yield bonds," pay the most return. When Treasury yields rise, so do these bonds to remain competitive.