The Pros and Cons of Higher Rates
February 23, 2016 | Your Finances
Short-term interest rates are trending upward for the first time in seven years and may go up more in 2016. While the initial increase of the short-term rates controlled by the Federal Reserve Board (Fed) was a small one, history has shown that once rates begin to rise, they continue to go up.
The direction of rates can affect your finances in many ways, including the cost of loans and interest you earn on savings. The first rate increase hasn’t impacted overall borrowing or savings rates much, but if the Fed continues to hike rates, they could have an impact on your finances.
There’s no way to know exactly how quickly or how much rates will rise. It’s a good idea to learn more about how changing rates might impact your borrowing, saving and investing during the next several years so you can be fully prepared.
The Fed decided to raise rates in December because it believed the U.S. economy was strong enough to grow on its own with less support from low interest rates. Specifically, the Fed believes that the currently low unemployment rate shows that the U.S. economy is in good shape.
The Fed’s mandate is to promote maximum employment, stable prices and moderate long-term interest rates. Inflation is the tendency of prices to increase. A prolonged period of low interest rates can create longer-term inflationary pressures. Low interest rates incent consumers and businesses to spend more, which can lead to higher employment and better pay. Eventually, rising demand can cause prices to increase faster, thus risking inflation. By raising rates, the Fed hopes to keep prices stable.
While the Fed doesn’t directly set interest rates on loans and savings accounts, it controls other rates that affect what banks charge for loans and pay out in interest.
The good news is that interest rate increases have no impact on existing fixed rate loans, whether those are mortgages or car or business loans. And because the rate increase was so small, you may not even notice any impact on your wallet or budget. Most families may not even notice that rates have increased.
While the number of rate hikes in 2016 is uncertain, it is reasonable to expect that over the next few years the Fed will increase short-term interest rates from today’s lows.
Rising Rates: What’s Likely to Go Up
Credit cards, adjustable-rate mortgages and lines of credit are areas in which you might feel the pinch of higher rates first. In the long term, rates for new fixed-rate mortgages and car loans will also get more expensive. On the positive side of the equation, savers will be rewarded with higher rates of interest, specifically for deposit accounts such as money market accounts, savings accounts and certificates of deposit.
1. Mortgages: Because a mortgage payment is the biggest expense that most families have, higher mortgage rates can impact family budgets more than other loan rate increases.
For example, a 1 percent increase on a 30-year fixed-rate mortgage of $250,000, from 4 to 5 percent, would increase the monthly payment from $1,193.54 to $1,342.05 ($148.51 a month). A 2 percent increase on a 30-year mortgage, from 4 to 6 percent, would push that monthly payment to $1,498.88, an increase of $305.34 for each monthly payment.
2. Credit cards: Most credit card rates are tied to the prime rate, which banks increased from 3.25 to 3.5 percent following the Fed rate hike. Average rates on cards rose slightly in response, to 15.81 percent at the beginning of February, up from 15.71 percent in November, according to Bankrate.com.1
Higher interest rates can do the most damage if you carry balances on your card. For example, if you carry a $3,000 balance with a 16 percent interest rate and make the minimum payment, you will pay $2,009.46 in interest, and it will take you more than 10 years to pay off the balance. The same $3,000 balance with a 19 percent interest rate and minimum monthly payments will increase your overall interest payments to $2,782.19 and will take almost 12 years to pay off.
3. Certificates of Deposit: CD rates are low today, but as rates continue to rise, CD rates will get more rewarding. For example, a five-year $10,000 CD with a one percent interest rate compounded annually will pay $510.10 in interest after five years. A five-year $10,000 CD with a two percent rate would pay $1,040.81 in interest after five years, while a three percent CD takes that up to $1,592.71.
Rising Rates: Impact Uncertain
1. Bonds and Bond Funds: Fixed-income investments are directly impacted by rate increases. When rates rise, existing bonds fall in value. However, over time, new bonds issued at higher rates mean that investors gain from higher interest rates. That’s because bonds issued at higher rates pay more interest, raising the interest that investors get from individual bonds and bond funds. While there may be losses early in the interest rate cycle for investors, eventually, higher interest payments from newly purchased bonds will help alleviate that pain.
2. Stocks and stock funds: Because bonds have yielded so little, many investors have moved into stocks and stock funds, which tend to be riskier. Higher rates could inspire investors to move back into bonds and bond funds, which could put pressure on prices for stocks in the short term. However, interest rates are one factor among many that impact the stock market, and rising rates should be commensurate with economic growth—a long-term positive for stocks. As long as the Fed successfully meets its mandate to keep inflation stable and long-term interest rates moderate, the impact of rising rates on stocks should be restrained.
The Bottom Line
In the long term, it’s likely that rates are on the way up. While the small rate increases won’t affect your finances much, over time interest rate increases can be both a blessing and a curse. Savers will receive more interest on their savings, but borrowers will get hit with higher payments for credit cards, car loans, mortgages and other types of loans.
All investments carry some level of risk and no investment strategy can guarantee a profit or protect against loss, including the potential loss of principal invested. Bonds, in addition to interest rate risk, are subject to duration and credit risk.
The opinions expressed are those of Northwestern Mutual and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI (fiduciary and fee-based financial planning services), subsidiary of NM, limited purpose federal savings bank.
1Bankrate.com, Current Credit Card Interest Rates http://www.bankrate.com/finance/credit-cards/current-interest-rates.aspx