November 28, 2022

Business Update Blog

Why Fed Rate Hikes Will Have Little Impact On Borrowing Costs

After three years, the Federal Reserve has finally begun hiking rates to help stem rising inflation. With the latest 7.9% inflation print, inflation is now at a 40-year high.

The Federal Reserve has telegraphed it will hike the Fed Funds rate 6-7 times over the next 12 months. Therefore, we could easily see 1% – 1.75% higher Fed Funds rates in the near future.

The Fed is behind the curve when it comes to hiking rates. And that’s understandable. The Fed would rather be a little too slow in hiking rates than a little too fast in order to help our economy survive a pandemic.

Put another way, which would you rather have, higher inflation and a stronger labor market, or lower inflation and a weaker labor market? The former is usually preferred. In an ideal world, the Fed would love to have 2%-2.5% inflation and 3.5% – 4% unemployment levels.

But the reality is, the upcoming Fed rate hikes will have a negligible impact on your finances, especially if you have been a regular Financial Samurai reader. Fed rate hikes won’t make borrowing costs that much greater. Therefore, for those of you who like to take out credit card debt, auto loans, student loans, and mortgage rates, I wouldn’t worry too much.

Let’s break down how Fed rate hikes will affect borrowing costs for each category.

How Fed Rate Hikes Affect Credit Cards

Since most personal finance enthusiasts don’t carry a revolving credit card balance, Fed rate hikes don’t matter for credit cards. Besides payday loans, credit card debt is the worst type of debt.

However, if you do carry a revolving credit card balance, you are likely paying an APR of between 16% – 17%. An average credit card interest rate of 16% – 17% is highway robbery when the 10-year bond yield is at only 2% and the Fed Funds rate is less than that. The historical annual return of the S&P 500 is about 10%, which makes paying 16% – 17% even more egregious.

Stop making credit card companies rich. Instead, make yourself rich by shunning credit card debt and investing over the long term instead. OK, enough about encouraging folks not to take on credit card debt.

Credit cards have a variable rate that follows the short end of the yield curve. The Fed Funds rate is at the shortest end of the yield curve. Specifically, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. This means credit card interest rates will likely increase by a similar magnitude as the latest Fed Funds rate hike.

So if you’re paying a 16% APR, you will likely start paying a 16.25% APR after the Fed hikes by 25 basis points. Can you really tell the difference if you carry revolving credit card debt? Unlikely. On a $10,000 credit card balance, your interest payment will go up by a mere $25 a year. Even a 1% interest rate hike is only an extra $100 a year. And that is if you hold the entire balance all year.

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Pay Down Your Credit Card Debt Or Consolidate ASAP

Given you know credit card interest rates are going up, if you have credit card debt, get motivated to pay down more credit card debt ASAP. Unless you also have payday loans, it is likely your most expensive debt. 

If you are having a difficult time paying down your credit card debt, you should be able to consolidate your debt by getting a personal loan at a lower interest rate. The average personal loan rate is much lower than the average credit card rate. You can check the latest personal loan rates for free on Credible.

How Fed Rate Hikes Affect Auto loans

Getting an auto loan is not a great idea given you’re buying an asset that is guaranteed to depreciate. Further, with gas prices so high, your ongoing ownership cost of a car is now higher. That said, if you need a car then you need a car.

A Fed rate hike won’t have a material effect on auto loans either. First of all, once you lock in your auto loan, the interest rate is generally fixed for the life of the loan.

Let’s say you buy a new $40,000 vehicle and put down $5,000. You borrow $35,000 over a 60-month period at a 3% interest rate. After taxes and fees, your monthly auto loan bill is $629. If the Fed ends up hiking the Fed Funds rate by 1% over the next 12 months, your auto loan payment will still be the same.

If you plan to buy the same car with the same conditions after a 1% increase in the auto loan rate, your monthly payment goes to $652.51 from $629. Not that big of a deal.

Ideally, you buy a car equal to 1/10th of your annual gross income and pay cash. Even if you take an auto loan or lease a car in this price range, the monthly payments will be negligible.

If you do lease a car, please be aware of the early termination penalties and ways you can get out of a lease. A lease is usually not the most cost-effective way to buy a car. But it makes getting rid of your car easier. Further, if you own a business, you can write off some or all of your lease payments and other costs of owning the vehicle.

Below is a great chart on historical average U.S. national gas prices. Given we’re much wealthier on average since 2008 and 2011, the last years gas prices got this high, higher gas prices shouldn’t negatively affect us as much.

National average gasoline prices

How Fed Rate Hikes Affect Mortgages

One of the biggest misunderstandings in personal finance is that the Federal Reserve controls mortgage rates. This is not true. The Fed has some influence over mortgage rates, but not nearly as much as the bond market does.

Mortgage rates more closely follow the 10-year Treasury bond yield, which is at the long end of the yield curve. If you’re thinking about getting a 5/1 ARM, 7/1 ARM, 10/1 ARM, 15-year fixed, or 30-year fixed mortgage, a Fed rate hike doesn’t matter so much. These types of mortgages are more affected by the 10-year Treasury bond yield.

If you were able to get a 1/1 ARM or a mortgage that adjusts every month, then your mortgage would see a stronger correlation with the Fed Funds rate. But most people in America get mortgage rates with fixed rates of three years and longer and mortgages that amortize over a 30-year period.

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However, higher Fed Funds rates will impact ARMs once their fixed-rate period expires. This is because most ARMs are based on a short-term rate index like LIBOR (London Interbank Offered Rate) that moves with the Fed Funds rate. These mortgages are often priced at LIBOR + a margin.

Below is an example of an adjustable-rate mortgage of 2.375% based on a one-year LIBOR + 2.25% margin. The most it can increase during year six is by 2.25%. And the maximum interest rate it will go to is 7.375%. I explain the process of an adjustable-rate mortgage increase if you’re interested.

Adjustable Interest Rate Table Financial Samurai

Preferred Types Of Mortgages

I prefer getting an ARM over a 30-year fixed mortgage due to the long-term downward trend of interest rates. More than likely, you will be able to refinance your ARM to the same rate or a lower rate before the fixed-rate period expires.

However, if you have the cash flow, getting a 15-year fixed mortgage will save you the most in interest. Further, you’ll more than likely pay off your mortgage sooner. The downside is having less money to invest in investments that may provide a greater return.

If you have a home equity line of credit (HELOC), it is pegged to the prime rate plus a margin. So when the Fed hikes rates, the HELOC adjusts immediately. Please use your HELOC responsibly.

If you’re looking to compare mortgage rates, you can check here. If the Fed indeed raises the Fed Funds rate by 1% – 1.75% over the next two years, as some have forecast, there will be upward pressure on mortgage rates. Therefore, you may want to refinance now.

How Fed Rate Hikes Affect Student loans

Given federal students loan rates are fixed, borrowers won’t be immediately impacted by a Fed rate hike. Private student loans, on the other hand, may be fixed or variable. Therefore, if you have a private student loan, you need to check how its interest rate is determined. Give the loan processor a ring and ask.

I’d try and refinance your student loan to a lower fixed rate if possible. Refinancing to a lower variable rate may not make sense given variable rates will go up.

How Fed Rate Hikes Affect Savings Rate

Savings rates are pitifully low. The current nationwide average savings rate is only about 0.06%. The average online savings rate is about 0.5%.

There is a correlation between savings rates and the Fed Funds rate. However, the correlation is not strong. Banks tend to lag way behind Fed rate hikes when it comes to raising deposit rates.

Check out this striking chart below. Notice how the national rate on non-jumbo deposits didn’t move despite the Fed hiking rates five times in two years.

Fed rate hikes and savings rate

Theoretically, net interest margins should increase as banks get to charge higher lending rates while maintaining their cost of funds. This is why conventional wisdom says to buy banks during a rising interest rate cycle. However, investment returns are obviously not guaranteed.

You can’t blame the banks for trying to maximize profits. It’s the same with gas stations slowly lowering their prices but quickly raising their prices. Businesses usually seek to make the most money possible.

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Don’t expect your savings rate to go up as the Fed hikes rates. View your savings at a bank not as a way to make a return, but as a way to provide liquidity and peace of mind. Yes, your savings get hurt by elevated inflation. However, earning a 0.5% nominal return is better than losing 20%+ in a bear market. Meanwhile, short-term CD rates should tick higher with higher Fed Funds rates.

How Fed Rate Hikes Affect Stock Margin Loans

The Fed has little effect on stock margin loan rates. Instead, stock margin loan rates are more determined by your collateral, the size of the loan, and how much risk the brokerage wants to take.

The brokerage sets the interest rate for the loan by establishing a base rate and either adding or subtracting a percentage based on the size of the loan. The larger the margin loan, the lower the margin interest rate.

Margin is the borrowing of money from your broker to buy a stock using your investment as collateral. Investors use margin to increase their purchasing power. However, I’m not a fan of going on margin to buy stocks given stocks are more volatile and provide no utility.

Tough Economic Conditions For The Federal Reserve To Navigate

The Federal Reserve should raise rates to help tame inflation. However, the Fed has to be careful raising rates too much and too quickly. Otherwise, it may help push our economy into a recession. If a recession happens, mass layoffs are sure to follow, which will increase the unemployment rate.

The hope is that higher energy prices are temporary and will abate once the tragic war started by Russia is over. A decline in stock prices should slow down marginal consumption by stock investors (~56% of Americans). Further, the pace of housing price appreciation should also slow as mortgage rates and housing prices rise.

In other words, the economy tends to be self-correcting. The Fed’s job is to engineer softer landings instead of having our economy go through boom-bust cycles. Four-to-six rate hikes in 12 months at 25 basis points (0.25%) each is nice and steady. Let’s see if the bond market agrees.

Perhaps the biggest threat to our economy is those consumers who’ve already taken on too much debt. Fed rate hikes could push some of these consumers into default, which could cause a cascade effect and hurt even the strongest consumer.

Therefore, it’s up to all of us to encourage everyone to be more careful taking on debt. Debt is more digestible when times are good. But once times turn bad, too much debt can crush your finances in a hurry.

Suggestion: If you have high interest credit card or other debt, you might be able to get a personal loan with a lower interest rate to pay off your higher interest rate debt. Check out Credible for free to see what competing lenders have to offer.

Readers, are you doing anything with your debt now that the Fed has started hiking interest rates? How many times and how much do you think the Fed should hike rates? In the next article, we’ll discuss how stocks have historically performed during a Fed rate-hike cycle.

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