How Will Rising Interest Rates Affect Families and Businesses?

Due to the real estate bubble and ensuing financial crisis, interest rates have been at historic lows.  The Federal Open Market Committee (FOMC), a division of the Federal Reserve overseeing the United States open market system, makes decisions about the federal funds rate, which in turn determines interest rates. Their goals include promoting maximum employment, stable prices and moderate long-term interest rates in the U.S. economy.

Improving economic conditions and lower unemployment have led to the FOMC raising the federal funds target rate by 25 basis points (added .25 percent  to previous estimates) to a range of 1.50 percent to 1.75 percent this month. The Fed expects to increase rates another three times this year and three more in 2019.  

To put this in perspective, the highest Fed Fund Rate was 20 percent back in March 1980 and the lowest was .25 percent in December 2008 (in response to the ‘Great Recession’). The average rate from 1971 through 2016 was 5.87 percent, which is still far above the current targets. This means while interest rates are rising, they are still far below normal levels and still accommodative.

How will rising interest rates affect families and businesses?  

Rates are already affecting mortgage refinancing. According to an article by Christina Rexrode in the Wall Street Journal entitled, “Homeowners Ditch Refinancings as Mortgage Rates Rise,” refinancings currently make up a smaller portion of the mortgage business than at any time in the past two decades.

As the federal funds rate increases, other corresponding rates also increase. The Prime Rate follows the Fed rate but is a few percentage points higher and many mortgage rates are based on the Prime Rate. For instance, the Prime Rate is currently 4.25 percent. Since the 1980 high in interest rates, the overall interest rate trend has been downward.

Now the rate is bottoming and the trend is set to reverse. If rates move higher, those with the lower locked-in rates of 30-year mortgages have no incentive to refinance. For borrowers, rising interest rates will mean higher costs. From companies looking to finance a project to individuals looking to buy their first home, financing costs will increase making larger projects and more expensive homes less affordable. The Wall Street Journal article notes that the number of borrowers eligible to refinance (those whose existing mortgage rate is higher than current mortgage rates) is at 2.6 million borrowers – down 37 percent from last year. The 30-year fixed mortgage rate has increased from 3.95 percent to 4.45 percent since the beginning of the year.

People also should be careful of variable rate loans. Home Equity Lines of Credit (HELOC) are almost always variable rate loans so be leery and keep an eye on your rates.

On the plus side, having an emergency savings is a must for financial success. When the refrigerator goes or the car starts making a funny noise, emergency savings come to the rescue. It helps pay for the unexpected and avoids the need for running up credit card debt in a tough situation. The key to emergency savings is safety of principal (you won’t lose money) and liquidity (you are able to pull from it when the emergency happens). Therefore, typically, emergency savings are held in savings or money markets.  

As the Fed increases rates, the interest earned on these accounts will increase, thus helping savers. Current rates are still abysmal. An inquiry made with two banks in State College, Northwest (NWBI) and PNC (PNC), found that interest rates on savings range from .05 percent to .15 percent, depending on the money deposited. Money markets, which may not be FDIC insured, range from .5 percent to .7 percent.  To get to 2.5 percent, you need to lock money away in a CD for five years and be a current customer of Northwest. Overall, we have a long way to go before saving pays.

In short, the Fed has been doing its job. To promote more growth, it lowered the target interest rates. This loosened up financing for cars, houses and business projects with less capital. It also discouraged savings as minimal interest is being earned. The Fed is starting to raise interest rates to avoid high inflation and keep prices stable (one of its key goals) as the pendulum swings to a healthier economy and strong employment.  

As we celebrate those improvements, remember to watch your spending, pay down your debt and be sure to maintain your emergency savings.

*Nothing contained in this article should be interpreted as a promise or guarantee of earnings or investment results nor a recommendation for the purchase or sale of any security or sector.