The Federal Reserve raised its target federal funds rate by 0.75 percentage points, the largest increase in nearly three decades, at the end of its two-day meeting Wednesday in an effort to quell runaway inflation.
“The motivation for all of this is that prices are going up,” said Chester Spatt, a professor of finance at Carnegie Mellon University’s Tepper School of Business. “The Fed is trying to fight that with higher interest rates to reduce demand.”
The latest move is only one part of a rate-hiking cycle, which aims to crush inflation without tipping the economy into a recession, as some fear could happen. The Fed last raised rates by 75 basis points in November 1994.
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“It had been 22 years since they raised rates by more than a quarter of a percentage point and now to be doing so at successive meetings, it really speaks to the urgency at hand,”said Greg McBride, chief financial analyst at Bankrate.com.
For consumers, this aggressive approach could eventually bring relief from surging prices. It also comes at a cost.
What the federal funds rate means to you
The federal funds rate, which is set by the central bank, is the interest rate at which banks borrow and lend to one another overnight. Although that’s not the rate that consumers pay, the Fed’s moves still affect the borrowing and saving rates they see every day.
“We’re certainly going to see the cost of borrowing escalate relatively quickly,” Spatt said.
With the backdrop of rising rates and future economic uncertainty, there are specific steps consumers should be taking to stabilize their finances, McBride added — including paying down debt, especially costly credit card and other variable rate debt, and increasing savings.
Pay down high-rate debt
Since most credit cards have a variable interest rate, there’s a direct connection to the Fed’s benchmark, so short-term borrowing rates are already heading higher.
Credit card rates are currently 16.61%, on average, significantly higher than nearly every other consumer loan and may closer to 19% by the end of the year — which would be a new record, according to Ted Rossman, a senior industry analyst at CreditCards.com.
If the APR on your credit card rises to 18.61% by the end of 2022, it will cost you another $832 in interest charges over the lifetime of the loan, assuming you made minimum payments on the average $5,525 balance, Rossman calculated.
If you’re carrying a balance, try consolidating and paying off high-interest credit cards with a lower interest home equity loan or personal loan or switch to an interest-free balance transfer credit card, he advised.
Consumers with an adjustable-rate mortgage or home equity lines of credit may also want to switch to a fixed rate, Spatt said.
Because longer-term 15-year and 30-year mortgage rates are fixed and tied to Treasury yields and the broader economy, those homeowners won’t be immediately impacted by a rate hike.
However, the average interest rate for a 30-year fixed-rate mortgage is also on the rise, reaching 6.28% this week — up more than three full percentage points from 3.11% at the end of December.
“Given that they’ve already gone up so dramatically, it’s difficult to say just how much higher mortgage rates will go by year’s end,” said Jacob Channel, senior economic analyst at LendingTree.
On a $300,000 loan, a 30-year, fixed-rate mortgage would cost you about $1,283 a month at a 3.11% rate. If you paid 6.28% instead, that would cost an extra $570 a month or $6,840 more a year and another $205,319 over the lifetime of the loan, according to Grow’s mortgage calculator.
Even though auto loans are fixed, payments are getting bigger because the price for all cars is rising, so if you are planning to finance a new car, you’ll shell out more in the months ahead.
Federal student loan rates are also fixed, so most borrowers won’t be impacted immediately by a rate hike. However, if you have a private loan, those loans may be fixed or have a variable rate tied to the Libor, prime or T-bill rates — which means that as the Fed raises rates, borrowers will likely pay more in interest, although how much more will vary by the benchmark.
That makes this a particularly good time identify the loans you have outstanding and see if refinancing makes sense.
Hunt for higher savings rates
While the Fed has no direct influence on deposit rates, they tend to be correlated to changes in the target federal funds rate. As a result, the savings account rate at some of the largest retail banks are barely above rock bottom, currently a mere 0.07%, on average.
“The rates paid by bigger banks are largely unchanged so where you have your savings is really important,” McBride said.
Thanks, in part, to lower overhead expenses, the average online savings account rate is closer to 1%, much higher than the average rate from a traditional, brick-and-mortar bank.
“If you have money sitting in a savings account earning 0.05%, moving that to a savings account paying 1% is an immediate twentyfold increase with further benefits still to come as interest rates rise,” according to McBride.
Top-yielding certificates of deposit, which pay about 1.5%, are even better than a high-yield savings account.
However, because the inflation rate is now higher than all of these rates, any money in savings loses purchasing power over time.
To that end, “one main opportunity out there is the possibility of buying some I bonds from the U.S. government,” Spatt said.
These inflation-protected assets, backed by the federal government, are nearly risk-free and pay a 9.62% annual rate through October, the highest yield on record.
Although there are purchase limits and you can’t tap the money for at least one year, you’ll score a much better return than a savings account or a one-year CD.
What’s coming next for interest rates
Consumers should prepare for even higher interest rates in the coming months.
Even though the Fed has already raised rates multiple times this year, more hikes are on the horizon as the central bank grapples with inflation.
While expectations for those increases had been quarter and half-point hikes at each meeting, the central bank could hand out further 50 or 75 basis point increases if inflation doesn’t start to cool down.