Interest Rate Hikes and Your Financial Plan
Hi everyone, and welcome back to Melissa Making Cents!
As a CERTIFIED FINANCIAL PLANNER™ and Financial Coach, I understand, perhaps as well as anyone else, that when it comes to your financial plan, there are things that are within your control and things that are not. One common misconception that people have is that they believe if they follow XYZ steps to the letter, they'll certainly have nothing but fantastic results and financial gains. While following sound financial practices may increase the odds of your financial life thriving, it's never a sure thing. There are always externalities that are out of the control of all of us.
Perhaps one of the most common externalities people face is medical emergencies. Unfortunately, these are things we can rarely plan for and often come with a significant financial hardship that may take precedence over whatever we're trying to accomplish in investing. However, even with emergencies like this, we can take several precautionary steps like creating an emergency fund or investing in disability insurance that will both ease the burden of medical expenses while you get back on your feet.
Another example of an externality that may affect your financial plan are interest rates! This is something that most of us don't regularly think about – and why should we? Well, as it turns out, interest rates, while seemingly abstract, have the potential to significantly impact our financial and everyday lives. That's why today we will discuss the who, what, where, when, and why of interest rates!
Who is "The Fed"?
Whether you're learning about interest rates, and their recent hikes, by reading articles, watching television, or listening to podcasts – you'll undoubtedly hear about "The Fed." However, many Americans aren't sure what that means, and others may have never heard of it. So, who or what is The Fed?
The Federal Reserve is what many of us refer to as "The Fed". Of course, it's not without controversy, but many see the Federal Reserve as the backbone of our financial system in the United States. They're the Central Bank of the United States responsible for creating and implementing monetary policies. In fact, according to the Federal Reserve, they are primarily accountable for five functions that promote the economy working in the public interest, including conducting monetary policy, maintaining the financial system's stability, supervising and regulating financial institutions, fostering payment and settlement system safety, and promoting consumer protection and community development.
The federal reserve comprises three branches, which act as checks and balances to keep banking and finances decentralized. Those three parts of the whole are The Federal Reserve Board of Governors, the 12 Federal Reserve Banks, and the Federal Open Market Committee. There's a ton of exciting and intriguing information about the Federal Reserve, which may make an excellent article some time down the road. Still, we'll stop here for now as that isn't totally necessary to you understand the Federal Reserve's role in Interest Rates.
The Interest Rate Basics
You'll recall that under the Fed's five essential functions, one is to maintain financial stability. Now, there are several tools at the Federal Reserve's disposal to accomplish their goals. However, one of the main tools they use is interest rates, which is the subject of today's article. Recently, the Federal Reserve announced through the Board of Governors that they've decided to raise interest rates; feel free to read over their announcement here.
The main questions that typically arise regarding these interest rates are What are they? How are they going to affect regular people? And what are average interest rates compared to what they are now?
Well, to put it simply – these interest rates are directly tied to banks and the financial system. When we say that the Federal Reserve is raising interest rates, that means that they're raising rates on bank overnight transfer borrowing. In practice, this means that everything from mortgages, credit cards, auto loans, and student loans will be more expensive. Raising interest rates is a significant move. It hasn't happened since 2018. The Federal Reserve's interest rate hike is aimed at overnight lending between banks, not directly to consumers. However, the cost of these hikes gets passed along to consumers.
To combat the economic toll of the pandemic, the Federal Reserve slashed interest rates to zero to spur the economy forward. However, their announcement unveiled they're raising rates from zero to .25%, with an overall expectation to continue raising interest rates to around two percent by the end of the year.
Raises in interest rates are frustrating to many who wonder why it's necessary. However, the goal of interest rates is to put a little bit of pressure on American consumer spending in an attempt to slow down spending. Slowing spending, in theory, reduces demand and combats inflation, which we're already beginning to feel the effects of around the country.
What Changing Interest Rates Mean for You and Me
Interest rates rising will directly or indirectly affect almost all of us. As we previously talked about, these rates aren't a direct rise to consumers; however, the rising cost to banks and financial institutions will be passed along to consumers by the banks. So here are a few things that you can expect to be a little more costly in the near future.
Historically, mortgage rates are at an all-time low. This is excellent news for consumers because we can borrow more for less! Also, mortgages aren't necessarily tied to Federal Reserve rates; they're connected to Treasury Bonds yields. However, rising inflation and expectations significantly affect the yields of these bonds, which means that soon the interest rates on mortgages may increase.
Credit cards are significantly affected by interest rate hikes by the Fed. As a result, cardholders can likely expect the interest rate on their purchases to go up within their cards' next few billing cycles.
Auto and Personal Loans
Auto loans, like mortgages, are affected by changes to treasury bond yields. However, instead of the 10-year yield associated with mortgages, auto loans are affected by 5-year bonds. Personal loan rates are more likely to be directly affected by banks increasing rates due to the Federal Reserve's hikes.
Existing student loans through the federal government shouldn't be affected by interest rate hikes because they're based on a fixed rate determined by the government. However, private student loan interest rates will likely rise.
Smaller banks historically are quick to the punch when it comes to offering higher interest rates on savings because they're interested in getting money into their system, which means they have to borrow less from the government and other banks. However, larger banks are already sitting on a pretty penny of saved funds from Americans. So while larger banks can be expected to raise interest rates on savings accounts eventually, it will take a bit longer than small banks.
How to Shield Yourself from Rising Interest Rates
There are several steps you can take and incorporate into your overarching financial plan to get as far ahead of rising interest rates as possible. For example, suppose you have quite a bit of credit card debt and are worried about the interest on your card increasing. In that case, you could take out a zero percent balance transfer which will allow you to work on paying down your debt with no extra interest for a period of time. You could also take the necessary steps to increase your credit score, which will allow you to get better interest rates overall when it comes to borrowing money.
However, I believe that the best step anyone can take is to get in touch with a quality financial planner or financial adviser and get their financial life planned, organized, and prepared for all sorts of scenarios. Professionals like myself know when to make great money moves that can shield you from inflation, rising interest rates, and other scenarios that will make a great deal of difference in your day-to-day life and your money-borrowing financial life.
If you're interested in getting together to discuss how to shield your financial wellbeing from rising interest rates and inflation in the face of uncertainty, please call or email to schedule an appointment with me. I'll work with you to create a financial plan that takes inflation, interest rates, and uncertainty into account.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.