| December 26, 2016

What the Interest Rate Hike Means for You

Now that the Fed raised rates, your credit card balances are likely to cost more.

The Federal Reserve took action last week and raised the target range for the federal funds rate from 0.5 to 0.75 percent. This was the second increase since the recovery began at end of the Great Recession.  And experts say you can expect more increases next year as the economy continues to perform as strongly as it has been.

Why does the Fed raise rates?

The Fed raises rates when the economy is strong in order to combat inflation. It’s a way to control the economy so prices don’t get out of control during periods of economic strength. Essentially, it’s a way to ensure the economy doesn’t over-perform, which can be just as bad when the economy under-performs.

When the economy is weak, the Fed lowers rates in order to encourage spending. When people are wary of a weak economic outlook, cutting benchmark interest rates in turn lowers rates offered by lenders. As a result, consumers are encouraged to borrow to take advantage of the low rates available. When the economy crashed in 2009, the Fed cut rates to near zero. That’s why lending rates on mortgages and other lines of credit have been so good for the past few years.

Now that the economy is performing well, an interest rate hike helps prevent inflation – the increase in prices over time. This helps ensure products remain affordable so consumers don’t have to cut back because things are too expensive.

Why does an interest rate hike affect my credit cards?

How the interest rate hike affects you

Most people understand that when the Fed raises rates, the interest rate on new loans and lines of credit will generally be higher. What may not be as obvious is how the rate hike affects your existing credit lines, such as your credit card debt.

By and large, most credit cards have variable interest rates. So when the Fed raises the federal funds rate, it affects the “prime rate” of lending. As a result the interest rates on your credit cards increase as well. This means your debts cost more money with each month that you carry a balance over.

Of course, half a percentage point may not seem like much, but it adds up. If you pay off a $5,000 credit card balance at 20% APR with minimum payments, total interest charges would be $9,196.96. At 20.5% APR total interest charges would be $9,913.02. So that half a percentage point results in $716.06 of additional interest charges.

In addition, most experts agree that this won’t be the last hike we see. The Fed is expected to continue rate increases periodically over the next year. This means there’s even more of a priority to eliminate your credit card balances now. Otherwise, you can expect it to cost more – and as a result take longer – to eliminate those high-interest balances.

Some good news about the interest rate hike

Sean McQuay from NerdWallet explains to MarketWatch, “Any money that is saved is going to be more valuable, and any debt outstanding will be more expensive.”

When the Fed raises rates, it not only affects the interest rates applied to your debts; it also affects the saving rates and yields applied to savings and cash equivalent investments, such as CDs. This means if you’re a saver, a higher rate by the Fed will result in more dividends on the money you have saved.

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