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Eight times a year 12 people you don’t know meet in a room to make decisions about your money. And, if you’re like most people, you don’t really pay attention to what they’re doing.
The Fed raised interest rates again yesterday, which means we now have the highest target fed funds rate since April 2008. What does that mean specifically for you and your money? I’ve got you covered with a little breakdown:
Remind me…what exactly is an interest rate?
Interest rates are the cost to borrow money. When you take out a student loan, for example, the lender charges you an interest rate to make up for the risk of you not repaying your loan and to compensate for inflation.
Inflation means that over time, a dollar can’t buy as much as it used to. Prices go up. Your lender needs to make sure they get back enough to compensate for inflation.
Inflation = the cost of your coffee today is less than the cost of your coffee tomorrow.
But on the flip side, you can also get paid interest. When you deposit money into a bank, they are effectively borrowing money from you. They make money by taking your deposit and lending it to other people. And to compensate you for this loan, they’ll pay you a (very) small amount of interest.
Why do interest rates change?
You probably hear about The Fed raising or lowering interest rates. “The Fed” = The Federal Reserve, the central bank in the US. They do a lot of things, but for this article, we’re just talking about interest rates.
The Fed has a Federal Open Market Committee (FOMC), which meets eight times per year to talk about things that directly affect you. Their goal is to keep the economy growing nicely, with low unemployment and an inflation rate of around 2% per year.
They do this by changing the target fed funds rate. You don’t need to know much about the target fed funds rate, but if you’re curious this is the rate that banks charge each other for overnight loans.
Fun fact: it’s called a target rate because the FOMC can’t force this rate, only influence it. But everyone pretty much falls in line.
If the FOMC is worried about the economy growing too quickly, they’ll increase interest rates to fight inflation. If they’re worried about the economy taking a dive, they’ll decrease interest rates. During the 2008 recession, we saw interest rates that were effectively zero. They kept those interest rates until they felt the recession was safely in our rearview mirror.
How do interest rate increases affect your wallet?
Ok right. We’ve done a little econ 101 lesson but you’re ready to move onto the good stuff. How do rising interest rates actually affect your money?
The good: compound interest
Remember the inflation rate that The Fed is trying to keep under control (to 2% per year)? It makes things more expensive tomorrow than they are today. But if you keep your money somewhere other than under your mattress, you can benefit from compound interest and come out ahead.
You’ve heard about compounding interest. But if you need a little refresher, I’ve got you. Compounding interest means that your money grows faster over time. Let’s say you put away $100 into a bond that earns 5% per year. After one year you have $105 ($100 * 1.05). After two years you have $110.25 ($105*1.05).
Not mind-blowing, I know. But long term that extra little bit that gets compounded adds up to a lot. After 30 years you’d have $432.19. When you put your money somewhere where you can take advantage of rising interest rates via compound interest, you’re winning.
What you can do to keep the good times rolling?
Rising interest rates give you the opportunity to reassess what you’re doing with your money. You’ll start to see banks adjusting their interest rates and offering savings accounts and CDs with higher interest rates.
This doesn’t mean you should abandon your investing plan. Historically, investments in the stock market and bond market have outperformed any return you’ll make in a savings account or CD. But if you are hanging out with your emergency fund money in a savings account that pays you a paltry amount in interest, it’s time to jump ship to one with a higher interest rate.
The bad: expensive debt repayment
When interest rates go up, the cost to borrow money goes up as well. This is where most people get into trouble. They either need to borrow during a high-interest rate environment or the interest rates on the money they’ve already borrowed will go up because they have debt with an adjustable rate.
Having a loan with an adjustable rate means the interest rate you pay will move up and down with changes in the interest rate. If interest rates go up, you’ll pay more for the money that you’ve already borrowed.
What can have an adjustable rate? Your mortgage, your loans (including student loans), and your credit cards.
Not sure if you have an adjustable rate or a fixed rate? Get your statements and find your interest rate. You might see something like ‘prime + X%’ or “LIBOR + X%”. That prime or LIBOR rate will increase when interest rates increase, which means you have variable debt.
What you can do to minimize the bad?
It’s time to put your effort into paying off any high-interest debt, especially when it comes with a variable rate. The amount you’re paying each month in interest is only going to go up. Here are some options to help you do that:
Refinance a variable rate mortgage
Refinancing your mortgage to a fixed rate can help shield you from rising rates, but it doesn’t always make sense. For example, refinancing a mortgage comes with fees (approximately 3% of the loan amount according to the Home Buying Institute). Do the math to see if you’ll save more money paying the fees and refinancing to a lower rate or whether it’s best to stick with your loan. This calculator can help.
Refinance student loan debt
I had friends who refinanced their student loans to variable rate private loans because the rate was a fantastic deal. They’ve been riding that low rate for a few years now, but at some point, they may want to refinance to a fixed rate. When you refinance your student loans, you shouldn’t have to pay any fees and with most lenders, the process is really simple. Shop around to see who will offer you the best-fixed rate. I refinanced my loans with SoFi and the process was incredibly smooth.
SoFi was one of the first to offer online student loan refinancing and let you combine both Federal and private student loans. Since then, a lot of other competitors have entered the space. Some other lenders you might consider are: Credible, Lendkey, Commonbond, Earnest.
Get rid of credit card debt
This should be your goal regardless of whether interest rates are rising. But with rising interest rates, your credit card debt about to get more expensive. To help give you a boost, shop around for a card with a better rate and do a 0% interest balance transfer.
Another option is to get a personal loan that comes with a fixed rate that is lower than your current credit card interest rate. Once you do that, don’t let that personal loan hang over your head – it will still have a high-interest rate. Shop around for the best rate at your local bank, credit union, or with Sofi.
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