December 19, 2015
The Fed's Interest Rate Hike - What does it mean for you?
The Fed has finally increased its federal funds rate - what does this mean for your family's finances?
The Fed’s Interest Rate Hike: What it Means for Your Family’s Finances
It’s finally happened! After a few false starts, the Federal Reserve has increased its federal funds rate to 0.25% (the interest rate banks and depository institutions charge one another for overnight loans with funds maintained at the Federal Reserve), raising a rate that has been near zero since December 2008. This increase has been one of the most anticipated economic events for some time; however, you’ll likely see little immediate impact to your family’s finances (both positive and negative), at least over the next year. While no one can say with 100% certainty the direction and magnitude of the federal rate hike on savings vehicles, loans and investments, here’s what I think you can expect in the short term for your family’s finances, and why.
Savings Accounts & Certificates of Deposit (CDs)
Particularly for deposit accounts held by banks, the Federal Reserve’s target rate is just one of a number of factors that determines the interest rates offered by banks for customers’ deposits. Banks are (generally) for-profit businesses, and factors like demand for loans and competition with other banks to attract deposits also impact a bank’s offer of interest on savings accounts and CDs. Like many businesses in the United States, banks right now are holding a lot of cash, and as such, there is little market incentive for them to raise rates to attract more deposits. In addition, history has shown that rates for savers mildly increase in response to incremental increases in the Federal funds rate; and that there is generally a time lag of several months before savers realize these higher rates. Shorter-term CDs (one year or less) will likely see an increase first in response to any target rate hike as they are generally pegged to the Federal Funds rate. Longer-term CD rates often take into consideration other benchmarks in addition to the Federal Funds rate, such as treasuries.
I wouldn’t expect an immediate or dramatic shift in savings account or CD rates; however, for investors who rely on these fixed income assets, a Federal Reserve rate hike might provide some relief by modestly increasing CD yield in the medium run. For savers seeking higher rates, investigate online banking institutions which often offer higher yields on savings accounts and CDs. Use savings vehicles such as savings accounts for your most liquid needs, such as your family’s emergency fund – do not use them to house your money earmarked for long-term goals, such as funding for college or retirement as the interest you receive will be overwhelmed by inflation, thus reducing your purchasing power.
Loans (Mortgages, Auto, Credit Card & Home Equity)
Because the Fed has been telegraphing its plans to raise rates for some time, today’s rate increase has already been priced into current mortgage rates. Furthermore, 30 year mortgages are priced off 10-year Treasury note yields, which do rise with Fed rate increases, but not as sharply. As a result, economists expect this rate hike to have no immediate impact on either Treasury or mortgage rates for fixed rate loans. Adjustable rate mortgages (ARMs) are more sensitive to rate hikes as many are modified annually, but even with further Fed rate hikes up to 1% over the next year, economists believe that ARM rates would adjust upward of just one-half of a percent. However, if your ARM is out of its fixed rate period and re-setting annually, it is probably wise to refinance into a fixed rate loan before these historically low rates disappear.
Auto industry experts indicate that Fed rate hikes are often fully reflected in the rates charged for auto loans, but with a six-month lag. So, if you are in the market for a new car, you might want to pull the trigger and buy now to take advantage of current rates before they rise.
Because of the variable nature of rates charged on home equity loans and credit cards, consumers holding this kind of debt will see a quick response to the Federal rate hike. Interest rates on home equity lines of credit are expected to increase in line with the Fed’s increases, and credit card holders are likely to see increases in just a few billing cycles as banks try to pass along their higher borrowing costs to consumers and businesses.
Bonds & Money Market Mutual Funds
The price of existing bonds tends to fall when the Fed increases its target rate as investors can buy new bonds issued at higher interest rates. However, because the Fed has been signaling this rate increase for some time, financial analysts believe the bond market has largely priced in the rate increase. Some analysts have expressed concern over the future of the bond market because interest rates are so low right now, these returns won’t compensate for further price drops that will occur with subsequent Federal rate hikes. Bond investors will likely want to keep a close eye on conditions in this market.
Investors in money market mutual funds can expect to realize an uptick in yield. Because these investment vehicles hold a mix of safe, low-risk investments such as short-term government securities and commercial paper that often mature within 30 to 40 days, the lag for the realization of this higher yield will be short. However, yields on these assets are well below 1% and increases are likely to be meager.
Outlook for Interest Rates
The Federal Reserve has signaled that this is the first of several rate hikes that it plans to implement to raise the target rate to about 1% by the end of 2016, and possibly higher into 2017, as it now forecasts. While Federal Reserve Chairperson Janet Yellen has stressed that the rate increases will be gradual, and that the impact of each rate increase will be assessed before the Fed pulls the trigger on the next one, the cumulative impact of increases on savings vehicles, loans and investments will be more pronounced. You might be tempted to fret about these increases, and hang on every word of every news report about future Federal Reserve meeting, but don’t you have better ways to spend your time? Instead, you are wiser to ensure that your investments are diversified, properly allocated, placed in (where appropriate) low-cost index funds, and positioned for your life-cycle stage as well as your short and long term financial goals.