As the Federal Reserve moves to hike its benchmark fed funds rate throughout 2022 to battle the highest inflation levels eroding consumer purchasing power at the grocery stores, how do higher interest rates affect consumers?
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Why Interest Rates Will Rise
Although the fed funds rate is not a consumer interest rate, raising it will lift most consumer borrowing rates. Robert J. Lloyd, CFA, President and Chief Investment Officer of Intrepid Wealth Management, notes, “The good news is the Fed will need to keep rates higher than inflation to suppress inflation. The bad news is that today we have high inflation and zero return on savings.”
The last time the Fed faced such pressures was in the late 1970s-1980s when inflation soared to 14.8% at its peak in 1980, and the Fed raised its fed funds rates to an all-time high of 20% in March 1980. No one believes we will revisit those extreme times. Still, consumers need to prepare for higher rates.
1. Consumers Should Limit Borrowing
Cady North, CFP and Founder of North Financial Advisors, says, “Rates that consumers pay never move directly in lockstep with the Fed rate increases, but over time, there will be changes for borrowers and savers.” Consumers should reduce discretionary spending during periods of higher rates and postpone any unnecessary borrowing as interest rates rise.
2. Avoid Carrying Large Balances On Your Credit Cards
Credit cards carry the highest borrowing rates of most consumer loan products, averaging 19.49%. Having large balances month to month at high rates makes it challenging to get rid of this costly debt. Try cutting your debt with the avalanche method, which targets this high cost of debt first.
3. Move To Conventional Mortgages Versus ARMs
If you have your heart set on buying a home this spring, the window will soon be closing on consumers seeking an affordable mortgage. Households already holding fixed mortgages of 15 or 30-year terms will not see any changes. Most (about 85%) prefer fixed-term mortgages with more predictable monthly payments.
Consumers with adjustable-rate mortgages or ARMs are at risk of paying higher borrowing rates. There are different ARM types, with a 10/1 ARM offering the most extended stability among ARMs, with a fixed ten-year period that will then adjust annually—the shorter the initial period, the more interest rate risk for the borrower.
Conventional 30 year fixed mortgage rates were expensive back in the early 1980s. Banks followed in the direction of the Fed when they lifted rates to peak levels in 1980, with average mortgage rates close to 17% in 1981.
4. Avoid Variable HELOC Loans
Your HELOC is a revolving line of credit secured by the equity in your home, often used to pay for home improvement projects. Most HELOCs are variable-rate loans that fluctuate with the prime rate but ask your bank for a fixed-rate option for customers who desire predictability in their budget.
5. Car Loans May Not Go Much Higher
Most car loan rates are at fixed terms pegged to Treasury yields. The higher interest rates may not affect car loans as much as the continued chip supply constraints in the short term.
6. Avoid Variable Student Loans
The rates for federal student fixed-term loans for college students move with the ten-year Treasury notes, which may be secure at current rates as it may be challenging for the federal government to raise these costs on college students.
Students will likely see higher interest rates on variable private loans.
7. Savers Will Earn More Income
When interest rates rise, households become more significant savers.
North continues, “It’s always a good idea to review interest rates on your savings accounts and comparison shop once every two years. In the last decade, it’s never been a good idea to stay put in one place (high yield savings versus Certificate of Deposit, for instance) for the long run. This is because different products are offered or incentivized at different rates, and one is not always higher than another.”
8. US Personal Savings Rate May Go Lower
During the late 1970s and early 1980s, the US personal savings rates were higher at double-digit rates, with 13.0% in October 1981, incented by banks seeking customer deposits. By 2019, US personal savings rates were 7.1%. Households were big savers during the pandemic, but the latest rate was 7.9% for December 2021, and more in line with 2019.
9. Consumers Will Not Earn A Windfall
Consumers earned minimal interest income with interest rates at paltry levels for savings accounts, CDs, and money market accounts since the Great Recession. As interest rates rise, banks, especially online banks, will offer higher-yielding products to consumers in return for their customer deposits. These FDIC-insured products are readily accessible for consumers to maintain emergency funds.
However, consumers will not necessarily earn a windfall from rising rates. A three-month CD rate was a juicy 18.07% in April 1980, but after adjusting for peaking inflation of 14.8%, the real rate of that CD was closer to 3.27%.
10. Where To Invest With Higher Rates
While the Fed raises short-term rates rather than long-term rates, the Fed’s actions directly influence long-term bond values.
Bond prices will fall when interest rates rise, adjusting to its lower fixed interest rate in the short term. Longer-term, rising interest rates will make bonds more attractive as money from maturing bonds goes into higher-yielding bonds. If prevailing interest rates rise, older bonds offering lower interest rates become less valuable in the secondary market.
According to Lloyd, “Investors have mostly bad choices in front of them. Stocks and bonds are overvalued, and as the Fed raises rates, many expect these valuations to fall to normal values. Additionally, in most Fed tightening cycles, a recession is triggered that hurts earnings and makes stocks fall even further.” Lloyd adds, “For our clients, we are underweight stocks and corporate bonds but overweight gold miners, silver, short-term Treasury bills, and floating-rate bonds.”
11. Inflation-Protection Bonds Are The Place To Be
Bonds with inflation-protection features are more attractive since they increase their payments in tandem with CPI changes. Top on the list is Series I Government savings bonds now offering 7.12% until the April reset and TIPs (Treasury Inflation-Protected securities) that adjust monthly with inflation.
12. Take A Longer Perspective When Buying Stocks
The stock market will remain volatile as it adjusts to higher interest rates. Certain companies may be more suitable for your stock portfolio, like businesses with low capital needs and can avoid heavy borrowing. Also, consider companies that can raise prices, for example, groceries or utilities. In times of rampant inflation, investors may seek real estate and commodities.
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With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.