As expected, the Federal Reserve hiked the short-term interest rate by one quarter of point at its March 2017 meeting. It marked the second time the rate was increased since December 2015 and it was only the third increase in a decade. Because the economy appears to be picking up some steam, the Fed is anticipating at least two more rate increases in 2018.
Small incremental increases in the short-term rate don’t necessarily have a direct impact on consumers. However, long-term rates have also been increasing due to a stronger economy and the prospect of higher inflation. Those are the rates tied to mortgages, loans and savings accounts that do affect your pocketbook.
What’s Behind Rising Interest Rates?
Near the end of 2016, the economy finally exhibited some long-awaited signs of strength. Before the election, long-term bond yields began to rise for the first time in awhile. Because mortgage rates are directly linked to long-term bond rates, they also jumped. Since the election the stock market has soared to record highs, which has driven bond yields even higher. The stock and bond markets are reacting to the optimism for a growing economy and the prospect of higher inflation that tends to accompany it. If the current trend continues, consumers can expect higher interest rates to impact their personal finances in the coming years.
Mortgage Rates Going Higher
In late 2016, mortgage rates, which had been hovering near historic lows, saw their first significant increase in several years. The average 30-year rate jumped from 3.4% just before the November elections, to a tick above 4%. Mortgage rates are linked to the Treasury bond rate, which began to rise at the first signs of a strengthening economy. A better than expected jobs report for February 2017 pushed the long-term rate up higher.
Morgage rate trends – last yearIf you already hold a fixed-rate mortgage, you won’t be affected by rising rates unless you have plans to refinance your loan. Now would be the time to refinance as there is no telling how much higher rates will increase. If you hold an adjustable-rate mortgage, you can expect your interest costs to increase, so now would be a good time to lock in a lower rate. For new homebuyers, mortgage rates are rising, but they are still attractive compared to a decade ago when they were near 7%.
Consumer Debt Will Be More Costly
If you hold any type of debt with a variable rate, you can expect your interest costs to creep up from now on. Most consumer loans with variable rates adjust once a year, while credit cards with variable APRs can adjust at any time.
Now would be the time to pay down your higher interest credit card debt or look for opportunities to transfer your balance to a 0% interest credit card for twelve months or longer and pay down the debt more quickly. Personal loans from a bank or credit union are typically issued with fixed rates for the term of the loan, so an increase in interest rates will not impact them. If you are uncertain how your consumer loan or credit card will be impacted by rising rates, you should contact your creditor to find out.
Savings Deposits Will Gain Traction
The good news is that savers will finally see an increase in their savings rate. The bad news is savings rates aren’t expected to rise very quickly or very far, at least for a while. Generally, rates on savings deposits tend to lag behind the increases on long-term rates.
Right now, banks are sitting on huge piles of cash, so they don’t feel the need to raise deposit rates to attract new money. The rates on money market accounts and CDs with longer maturities may rise a little faster than savings accounts.
Long-Term Investments Should Be Diversified
Rising interest rates have a direct impact on bonds. When the yields on bonds increase, their value decreases. However, bonds held to maturity are still redeemed for full value. If you plan on selling a bond in this environment, you are likely to receive less than its value today.
If you own a bond mutual fund, you are likely to see a decrease in share value, but, as the fund adds newer, higher yielding bonds, you should also see an increase in the fund’s yield. Risk adverse bond investors should consider rolling a portion of their portfolio into short-term bonds or short-term bond funds, which aren’t as sensitive to interest rate changes.
Equity investments, such as stocks, stock exchange-traded funds and stock mutual funds, can be a little trickier. Generally, higher interest rates and inflation can have an adverse effect on some stocks. Higher interest rates increase the cost of borrowing for companies which can limit their growth. Higher inflation can also increase costs for companies, which can eat into profits.
However, during a period of economic expansion, which is driven by higher corporate earnings, stocks should perform well. It is when the economy starts to overheat that higher interest rates and inflation can spike, causing stock prices to fall.
Regardless of the interest rate environment, the key to sound, long-term investing is to make sure your portfolio is well-diversified with a range of different assets. Stocks tend to perform well when bonds aren’t and vice versa, so it is recommended that your portfolio be balanced with a mix of both.
Time to Recalibrate Your Personal Finances
Increasing interest rates are a normal part of the economic cycle. Borrowers have benefited greatly, but people who rely upon yields for their savings or income have struggled. As it does with some regularity, the economic cycle is shifting to where it will begin to favor savers over borrowers. Although you are not likely to see the kind of spike in rates experienced in the 1970s and 1980s, it would be important for you to assess your current financial situation to determine how it will be affected by rising interest rates.