With inflation on the rise, there’s a lot of focus on interest rates. Among their many impacts in our economy, interest rates are one of the tools used by the federal government to help combat inflation.
Based on reports and announcements from the Federal Reserve — also known as the central bank of the U.S. — we know that interest rates will go up multiple times this year. In fact, they’ve already been raised once. These increases come after more than a decade of low interest rates and expansionary economic policies geared toward spurring growth.
During this time of economic uncertainty (Will inflation finally begin to slow? Will pandemic supply-chain issues be resolved? Will labor shortages stabilize? Will housing prices come down?), it’s reasonable to wonder: How will higher interest rates affect me? Here’s what you need to know about interest rates and how they could impact your financial plan.
What are interest rates?
Put simply, interest rates are the cost of borrowing money. In a typical financing deal, there’s a borrower (someone who needs access to cash) and a lender (someone who already has access to cash). When lending money, there’s always some probability or risk that the borrower won’t actually repay it. To minimize this risk exposure and gain something from loaning their money, lenders charge interest. The amount of interest they charge is determined by the interest rate.
Mortgage interest rates are a well-known example. Let’s say you purchase a new home and take out a mortgage for $300,000. For this example, we’ll assume the interest rate is 5%. With a balance of $300,000 on the mortgage, your monthly interest payment would be $1,250 ((300,000 x 0.05)/12).
It’s almost a certainty that you are or at some point will be involved in a financial deal that involves interest. Depending on the situation, you may be the one paying the interest rate (that is, you’re borrowing money from someone or some financial institution) or you may be the one earning interest (that is, you’re lending your money to someone or some financial institution).
Who controls interest rates?
At risk of oversimplifying, we’ll start by acknowledging that U.S. monetary policy is complicated. That said, in general, the Federal Reserve (or, more specifically, the Federal Open Market Committee) attempts to control interest rates by adjusting the federal funds rate. The federal funds rate is the average rate banks pay each other for overnight loans. You might have heard that the Fed recently raised the federal funds rate range from 0–0.25% to 0.25–0.50%.
By setting the federal funds rate, the Fed changes the incentive financial institutions have to borrow and lend money to each other. When the federal funds rate goes up, the cost of borrowing between banks goes up. This creates a ripple effect across the economy and influences other interest rates, including ones banks charge consumers.
So, it’s most accurate to say that the Federal Reserve directly controls the federal funds rate, and thus has an influence (but not direct control) on other interest rates, like the prime lending rate, auto loans, and mortgages.
Interest rates and inflation
The primary reason a lot of people have recently become hyper-aware of interest rates is because of their relationship with inflation. It’s no secret that we’re currently seeing high levels of inflation across the U.S. In response, there have been numerous headlines and conversations about the Fed increasing interest rates to try and slow inflation down.
To understand the relationship between inflation, it’s important to have a general understanding of the relationship between interest rates and economic growth. In most cases:
- When interest rates go up, the economy usually shrinks (or economic growth slows). This is primarily because the cost of borrowing money goes up, so fewer people and businesses are willing to borrow. Instead, they’ll choose to use their own capital, which can take time to save up. The immediate impact is less purchasing power, lower money supply in the economy, fewer exchanges of goods and services, and less production.
- When interest rates go down, the economy usually expands (or economic growth speeds up). At low interest rates, borrowing money is much more attractive to consumers and businesses. This leads to increased demand for goods and services, ramped up production, more disposable income, and a stimulated economy. During periods of economic depression, the Fed will typically slash interest rates to influence growth.
Okay, so what does this have to do with inflation? Well, we know what causes rising inflation: primarily excess cash in the marketplace and sudden imbalances in supply and demand. And, more specifically, we know the root causes of today’s increasing inflation: economic policies in response to COVID-19 (namely stimulus checks, forgivable PPP loans, additional tax credits, and a pause on student loan payments) coupled with supply-chain issues and staffing shortages created by the pandemic and the war in Ukraine.
Facing high inflation caused by excess cash, increased demand, and supply shortages, the Fed will increase interest rates to reduce lending, dampen demand, and in time, allow supply to catch up. The overall intended effect is for consumer demand to decrease which should lead to greater balance in supply and demand and stabilized prices for goods and services.
How do interest rates impact your financial plan?
Interest rates and the stock market
The impact interest rates have on the stock market vary over time and across industries. Ultimately, how a particular stock is affected by rising interest rates (and the degree to which it is impacted) is largely determined by a corporation’s ability to change the cost of its goods and services.
This is especially true during times of high inflation. Think about it: When the costs to produce goods and services go up, a company often needs to raise prices to maintain or grow its business value. If the company isn’t able to increase its prices proportionate to its expenses, its earnings (and likely its stock) will be negatively impacted. On the flip side, if a company is able to increase its prices, it can maintain its profit margin. In this case, controlling all other variables, the stock price is likely to hold steady or increase.
Sometimes, when interest rates increase, we see at least a temporary drop in stock prices. That’s because the cost of borrowing increases, causing demand to go down. When demand goes down, corporations aren’t able to easily increase their prices. Until the rest of the supply chain catches up, many consumer-facing industries won’t be able to increase what they charge consumers, but they may still be faced with higher manufacturing and labor costs. As a result, they’ll have weaker profit margins.
Before the Fed’s interest rate increase in March 2022, stocks continued to perform relatively well in spite of high inflation. That’s because most corporations were in a position to continue borrowing money cheaply while also increasing the prices they charged consumers, primarily as a result of high demand and short supply. This led to higher prices for consumers (i.e. inflation) but consistent profit margins for corporations.
As interest rates go up, however, this has changed. Many companies invest in their growth by leveraging good debt through financing deals. As companies invest in themselves, stock prices and valuations tend to go up. With rising interest rates, the cost of debt (that is, the cost of borrowing) will go up. This will likely lead to fewer companies borrowing money to reinvest in their businesses (i.e., buying new equipment, investing in innovation, hiring more employees), which will ultimately slow expansion and could lead to lower stock prices.
Some good news for investors worried about rising interest rates: the US equity market has delivered strong longer-term performance on average — regardless of hikes in the fed funds rate. And the average stock market return in months with target rate increases is similar to the average return in months with decreases or no changes in target rates.
Interest rates and bonds
Bonds are fixed-income securities that act essentially as loans to the issuing institution (usually a corporation or government entity) and serve as an alternative investment to traditional stocks. Similar to most common loans, bonds have specific and agreed upon terms, including an end date (or maturity date) when the bond principal is due and the bond’s interest, which is typically calculated at a fixed rate and referred to as a “coupon.”
Like traditional stocks and equities, lenders (that is bondholders) can sell their bonds to other investors and buy bonds from other bondholders. In other words, they don’t have to hold a bond until its maturity date.
Typically, as interest rates go up, prices in the bond market will decrease. That’s because most bonds have a fixed interest rate. As interest rates go up, existing bonds issued at lower rates become less attractive to investors who want to maximize their return. When the investment becomes less attractive, its price falls. Conversely, bondholders stand to benefit when the federal funds rate decreases, because their existing bonds have higher coupon rates, making them more attractive and allowing the bondholder to sell at a premium (if they wish to sell prior to maturity).
Interest rates and loans
Beyond investments like stocks and bonds, most people will notice a direct impact caused by higher interest rates with loan costs. Specifically, mortgage rates, auto loans, personal loans, student loans, and credit cards. As mentioned earlier, although the Fed does not directly control these interest rates, their ability to adjust the federal funds rate influences the others. So when the federal funds rate goes up, other interest rates tend to follow. And as they do, the cost of financing (or borrowing) becomes more expensive. You’ll feel those higher prices if you take out a new mortgage or finance a new car.
In many cases, privately-held debt (like private student loans and credit cards) carries a variable interest rate. Unlike fixed-rate debt, variable interest rates can change. That means as the overall interest rate environment changes (i.e., the federal funds rate changes), so too can the amount of interest you owe on existing debt. Some common illustrations are home equity lines of credit (HELOCs) and adjustable-rate mortgages (ARMs).
Over the past few years, there’s been a strong incentive for homeowners with an ARM to refinance their mortgage to a fixed-rate mortgage so they could lock in historically low rates. Those with an ARM who chose not to refinance should expect their interest rate and mortgage payments to go up in the near future as interest rates increase.
Ultimately, when interest rates go up, the cost to borrow money goes up. Depending on how high interest rates go, this could have a significant impact on monthly loan payments for mortgages, cars, credit cards, and student loans, as well as increase the total amount of interest paid over the life of these loans. This will almost certainly impact any new financing agreements, but it will also have an effect on anyone who holds debt with a variable interest rate.
On the other hand, when interest rates go down, the cost to borrow goes down. Periods with historically low interest rates provide an opportunity to refinance existing loans or consolidate debt to take advantage of more competitive rates. During these times, you may also have a greater incentive to make financial decisions that require you to incur debt since the cost of borrowing money will be lower.
Interest rates and bank accounts
Another area where you may notice a direct — yet likely smaller — impact is with the interest rates on your checking account, savings account, or Certificate of Deposit (CD). These interest rates on deposit accounts, commonly referred to as annual percentage yields (APYs), are also influenced by the federal funds rate.
This makes sense when you think about what banks do with your deposit accounts. When you open an account with a bank and deposit cash into it, you’re essentially “loaning” them your money that they then package into financial products — such as mortgages, personal loans, and auto loans — and offer to other consumers and charge interest on.
As the interest banks charge consumers increases, the amount of interest they’re willing to pay consumers to hold their deposits also increases. When interest rates go up, banks have more to gain by “borrowing” your money so they can provide more loans to more people. As a result, banks will offer stronger incentives (i.e., paying higher APYs on savings, checking, and CD accounts) so that more people will open accounts and deposit money with them.
Increases to interest rates offered by bank accounts typically lag behind other interest rates (like mortgages and auto loans). They’re also usually more incremental and, thus, unlikely to offset the higher amounts of interest most consumers will pay because of increased rates on mortgages, auto loans, and other personal debt. That said, they do provide a greater benefit for people on their cash accounts and create stronger competition and choice among consumer banks.
Conclusion: How will higher interest rates impact me?
Truthfully, there is no cookie-cutter answer for how an interest rate change will impact everyone. There are plenty of variables at play, including credit worthiness, the amount and type of debt you owe, and whether or not you have current or future plans to take out a loan. Ultimately, rising rates will have the most direct impact on new borrowers and people with existing variable rate debt (like HELOCs, ARMs, and credit cards). In general, here’s what you can expect:
- You will have to pay more total interest on new mortgages, auto loans, credit card debt, personal loans, and any existing debt with variable rates. This will also lead to higher monthly payments. Ultimately, you will have to pay more for anything that requires new financing or variable rates.
- As borrowing costs increase, corporations are likely to experience slower growth. They’ll be more hesitant to take out loans to invest in expansion. As a result, earnings and stock prices may grow more slowly, stagnate, or even decline. It’s highly unlikely during periods of rate increases for the stock market to perform as strongly as it has in recent years.
- You will earn marginally more on your cash deposits as financial institutions raise annual percentage yields (the interest it pays consumers) on savings, checking, Certificate of Deposits (CDs), and other deposit accounts.
- As fewer people borrow money to make purchases, demand for goods and services should go down. The intended result is for supply to catch up and the prices of goods and services to stabilize or decrease to curb inflation.
- If you’re looking to buy a new home, you’ll likely continue to find low housing supply. With higher rates, current homeowners who have locked in historically low interest rates are incentivized to hold onto their current mortgages instead of selling.
- Depending on how high interest rates become, you may decide to direct more money toward paying down debt more aggressively, which limits the amount of money you have to invest and save. Additionally, it might make sense to access cash or money from your portfolio to make purchases instead of financing. In either case, the end result is less disposable income.
- You may have greater opportunities to redirect some of your cash holdings (i.e., checking and savings accounts) to short-term duration investments, like Treasury Bills and Series I Bonds, as these fixed-income securities will likely offer a relatively higher rate of return than deposit accounts. Since these are government-based securities, the rates often adjust more quickly. In addition, the interest earnings potential on I Bonds benefits from both a fixed rate and inflation rate.
It’s important to remember that higher interest rates are actually a sign of a (somewhat overly) strong economy. Monetary policy is a delicate balance of push-and-pull with plenty of lagging indicators. While we’re focused on rising interest rates right now because of high inflation, we’ve seen the Fed slash rates many times in recent years to stimulate growth and protect the economy (i.e., 2008 recession and the early days of the COVID-19 pandemic). The Fed is raising rates now to combat inflation and put more powerful tools in its tool belt to stimulate the economy when it's needed in the future.
At the end of the day, there’s some understandable level of uncertainty. With interest rates on the rise, we’re navigating an economy the likes of which we haven’t seen in decades. As a result, you may need to reassess some financial decisions and approach new ones with a different mindset.
When evaluating those decisions, it may be helpful to work with an experienced financial planning team. These are the types of decisions and complex situations we help our clients prepare for and navigate every day. If you think it might be helpful for you to work with our advisory team, we’re here for you. Whenever you’re ready, you can book a discovery call to share your goals with us and learn more about our services.