Another interest rate hike just happened – are you prepared?
The Federal Reserve increased interest rates at its December meeting. And though the Fed can’t actually “set” interest rates for financial products, its changes will be felt throughout the market.
When the Fed raises interest rates, it’s actually boosting the target of one specific rate: the federal funds rate. This is the rate that banks charge one another for overnight loans.
Because the federal funds rate is basically the “cost” of money for banks, as the federal funds rate rises so does the “price” of all bank loan products.
For example, the prime rate tends to be set at 3 percentage points above the federal funds rate. The prime rate is then used as a benchmark for many short-term financial products, including credit cards and home equity lines of credit.
Keep track of leading rates such as the federal funds rate and prime rate.
Spenders and savers can benefit from a rate increase. No matter what side of the table you’re on, there are steps you can take to prepare your finances and use a rate hike to your advantage.
How to take advantage of a rate increase
1. Capitalize on rising deposit-account earnings
Savings accounts, certificates of deposit and money market accounts move nearly in lockstep with the federal funds rate. When the Fed pushes down rates, your savings account is one of the first places you feel that drop; vice versa when they rise.
Since the Fed is likely to continue raising rates (though likely not as frequently as previously thought), the increases in deposit account rates likely gradually rise. But that doesn’t mean you shouldn’t be saving money in these ultra-safe vehicles.
Experts recommend: Keep three to six months’ worth of expenses stowed away in an emergency fund. Those reserves should be placed in accounts insured by the Federal Deposit Insurance Corp. or the National Credit Union Administration. Learn how to build an emergency fund and where to stash the money.
2. Consider a low-interest car loan now
Although it isn’t a direct relationship, a low federal funds rate does help keep interest rates for auto loans low.
Interest rates for auto loans also depend on factors such as your credit score, the price of the car and the overall terms of the car sale.
Rather than shopping for cars based on interest rates, figure out what you can afford each month.
Experts recommend: Finance that car purchase now, before rates rise, but only if buying a vehicle fits into your larger financial picture. Also weigh factors such as the down payment and maintaining a good credit score to keep your loan amount lower.
3. Mind your student loans
The market does not set interest rates on federal student loans — the U.S. Congress does.
However, if you want to get rid of your debt faster, you may be able to pay them off by consolidating your debt with another loan, such as a home equity loan or a personal loan that may have a lower interest rate.
But take into account the tax benefits of student loans. Plus, in some cases these loans can be canceled, forgiven or discharged.
Experts recommend: Take out student loans wisely if they will lead to future opportunities. But talk to an adviser before rolling them into another loan instrument.
How to prevent being hurt by a rate increase
1. Act quickly on mortgages
The Federal Reserve exerts an indirect influence on mortgages. Mortgage rates sometimes increase when the Fed raises rates. And sometimes mortgage rates decrease following a rate hike.
But in a rising rate environment such as this one, consider your home first. On a $200,000 mortgage, half of 1 percentage point of interest means a difference of $20,000 or more over 30 years.
However, just because mortgage rates may rise in the future doesn’t mean you should take out a mortgage without thinking everything through.
Experts recommend: If you are in the market to buy a house or to refinance your mortgage, act sooner rather than later.
2. Watch out for rising HELOC rates
Home equity lines of credit have variable rates that are linked to the prime rate. That means HELOC rates rise when the Fed increases the federal funds rate.
If you’ve been planning on using a HELOC, do it now before the interest rate hike.
In contrast, rates on fixed-rate home equity loans don’t respond directly to the Fed. They are set by the market forces of supply and demand.
Compare rates on home equity lines of credit in your area.
3. Consolidate credit card debt
Credit cards are closely tied to the federal funds rate – you could see a rate increase as early as your next statement. If you’re carrying a balance on a card, it might make sense to roll that balance into a low-interest card or home equity loan.
But beware. If that credit card debt came from overspending, simply consolidating it into another loan won’t solve the underlying problem. If overspending was the cause, move cautiously when consolidating.
Experts recommend: Take advantage of low-interest credit cards to refinance high-interest cards, but do this only after you fix your spending problems.
4. Don’t borrow to invest
With interest rates still low, you may feel tempted to borrow money to play the stock market.
Don’t. Even though the current bull market has lasted almost a decade, it’s impossible to predict what will happen in the future.
Experts recommend: Invest cautiously in the stock market, but don’t borrow money to invest.
Keep in mind that the sooner you act, the sooner you’ll reap the benefits of jumping on or going on the defense of a rate increase.