Rising interest rates have an effect on borrowers, savers and homebuyers as well as the wider economy. In this article we concentrate on the impact of interest rates on consumers, and how you can prepare yourself with the minimum of financial losses with information about:
- How a higher interest rate will affect borrowing
- How higher interest rates will impact savings
- Whether to buy a home
- How higher interest rates influence economic growth
Throughout history, interest rates have fluctuated between 1% to 19% according to the federal funds target rate set by the Federal Reserve. Since the financial recession of 2008, they have been set at an all-time low. This has encouraged Americans to borrow but has been less of an incentive to save. However, the problem has not been the recent rise to just over 2%, but the hints that further rises are on the way, so rates are predicted to reach 3.4% in 2020. In this article, we examine how a further hike in interest rates will affect millions of Americans who have one or more financial products. Is there anything you can do to prepare yourself for this increase?
How will a higher interest rate affect borrowing?
Money that you have borrowed with a fixed rate will be unaffected by a rise in interest rates. Therefore, you don’t need to worry about most car loans, federal student loans or fixed rate personal loans or mortgages because their interest remains the same for the entire loan period. There are 2 financial products which will be affected: credit cards and adjustable rate mortgages (or ARM).
The main problem with credit cards is that there isn’t a fixed rate nor a fixed term. This can cause problems if you don’t pay off the balance every month. According to Experian, the average American has an outstanding balance of $6,354 so even a small increase in the increase rate will see millions of borrowers struggling to repay the money they owe.
In preparation for an rise in the interest rate, you should make every effort to bring down the outstanding balance on your credit cards. Make changes to your budget and everyday expenditure to pay back as much as you can. You should also try to avoid borrowing more on your cards as much as possible.
Adjustable rate mortgages (ARM)
If you have taken out a adjustable rate mortgage, now is the time to think about refinancing your loan and switching to a fixed rate mortgage. In this way, you avoid possible rises in your monthly installments as your payments are reevaluated. You might not see immediate savings, but you’ll be glad you did if interest rates exceed 3-4%.
How will higher interest rates impact savings?
Although the average interest rate on savings now stands at 0.1%, some online banks offer 2%. Despite this major difference, this is still much lower than the inflation rate which is 2.7% according to the Department of Labor. Over the past decade, this has discouraged many people from saving since they’re actually losing money if they leave it in a bank account. This will change if interest rates rise as putting money by will earn savers more. Unfortunately, this is something that won’t happen straightaway. Financial institutions are notorious for passing on rises to borrowers immediately, but are much slower in passing the same increases in interest rates on to savers.
Once savings accounts do begin to reflect the true value of interest rates, it’s a golden opportunity to put more money by and earn interest. Like any financial product, take the time to check out the market and see which account/institution offers you the best return. Some savings accounts require you to lock your money away for a fixed period otherwise you’re penalized. Choose a shorter-term so you aren’t stuck with a lower rate if interest rates continue to climb.
Should you buy a home?
If you’re thinking of purchasing real estate, you should consider taking out a mortgage loan with a fixed rate so you know exactly how much your monthly installments will be. Higher interest rates tend to discourage people from buying. As a result of this, the price of real estate tends to fall. For this reason, you may be able to find a more valuable home for a much cheaper price if you adopt a wait-and-see policy and even taking into account a higher interest rate on your borrowing.
Insurance cover can protect you from major financial losses caused by a downturn in the economy.
The other factor to bear in mind is that fewer people buying means that there is increasing competition for rental properties. This drives up the average price of rent so you may find that it makes better financial sense to buy instead of renting. You should do the math and see what is best for your circumstances.
How do higher interest rates influence economic growth?
The effects of higher interest rates on economic growth are extremely difficult to predict, and even experts disagree about what might happen. One theory is that businesses are also hit by higher charges on their borrowing so they might choose to pay this off and reduce investment and expansion plans. This situation can be made worse if it’s accompanied by drops in consumer spending because borrowing is too costly. All of this adds up to slow economic growth. Other experts predict the exact opposite happening saying that interest rates fluctuate according to the economy and not the other way round.
The government will also be hit by more expensive borrowing for the national debt. This is often resolved by higher taxes and budget cuts. In many ways, what happens to the economy is out of your direct control. Despite this, there are some preparations you can make in case of slower economic growth and any possible effect on your job. It’s more important than ever that you have an emergency fund to cover you for 6 months of your day-to-day expenditure (though 12 months would be preferable). You should also review all your insurance policies and make sure that they’re up-to-date. Insurance cover can protect you from major financial losses caused by a downturn in the economy.
Conclusion – Be prepared
Nobody knows with any degree of certainty about what will happen to interest rates and the impact on the US economy. However, much of the advice in this article such as paying off highly-priced credit products (like credit cards); building up an emergency fund or avoiding new debt will still stand you in good stead even if interest rates don’t rise dramatically.