How rising interest rates affect you and what you can do about it
How interest rates affect your monthly payments and the cost of debt
According to the Congressional Budget Office’s most recent budget and economic projection, interest costs grew by 35% in 2022 and are projected to grow by another 35% in 2023.
Here we’ll explain what causes rates to rise and how higher rates can impact your ability to get new loans and pay back existing ones.
What causes interest rates to rise?
It all starts with supply and demand. If there is an increased demand for loans and credit, there will be less available to borrow. When this happens, interest rates will rise. In theory, raising interest rates will discourage people from borrowing more money, therefore reducing the demand. It can also encourage borrowers to repay their loans and credit cards sooner to reduce the total interest they will have to pay.
Inflation can also impact interest rates. Lenders may increase interest rates when the inflation rate is high, to compensate for the increased cost of doing business.
The federal funds rate is another factor to consider. This is the interest rate that is used when depository institutions trade federal funds that are held at the Federal Reserve Bank (aka “the Fed”). The federal funds rate is set by the Federal Open Market Committee (FOMC) and influences the interest rates of mortgages, loans and savings accounts.
How do rising interest rates affect debt?
This depends on whether the existing debt is a fixed loan or a variable loan. Fixed loans are loans that lock in an interest rate when they are originated. Mortgages can come with a fixed rate, as can personal loans and auto loans. If a loan is a fixed loan, it will not be affected by rising debt unless the borrower chooses to refinance the loan. When a fixed loan is refinanced, the new loan amount will be subject to a new interest rate.
Variable interest rates are often associated with credit card debt, but loans can also have variable rates. This includes adjustable rate mortgages, student loans, home equity lines of credit (HELOC) and personal lines of credit (PLOC.) Variable interest rates can be lower than fixed interest rates when the loan is originated, but rising interest rates over time will increase the total amount paid in interest payments.
Higher monthly payments
Unlike fixed interest rates, variable interest rates on debt, like credit cards and lines of credit, fluctuate over the lifetime of a loan. They can also be referred to as adjustable or floating rates.
When the interest rate changes, most variable-rate loans will start to charge the new interest rate within one to two billing cycles following the change. For fixed-term loans, like mortgages, a rate increase means a higher monthly payment. For revolving accounts, like credit cards or lines of credit, higher rates mean less of your monthly payment goes to the principal, so it will take longer to pay off your balance.
Reduced borrowing capacity
An interest rate increase can impact your borrowing power and make it more difficult to borrow money. You might find that you don’t qualify for the amount of money that you would have before the increase in interest rates. In some cases, it might become more difficult to get approved for a loan at all.
The reality of this scenario hits prospective homeowners the hardest. Getting pre-qualified or pre-approved for a mortgage is typically the first step in buying a property. You can get a sense of how much money you might be eligible to borrow, estimated fees and closing costs, along with an example of a monthly payment. For people to have a realistic notion of how much they can spend on a home and how much they can contribute to a monthly mortgage payment, mortgage pre-qualifications and pre-approvals are helpful.
In some cases, applying for pre-qualification or pre-approval can lead to a realization that buying a home is not possible at the time. In others, a rate increase between pre-approval and finding a home can completely change the situation and force prospective buyers to reevaluate their budget.
If you’re looking to borrow money, it’s important to monitor changing interest rates because it can impact loans or lines of credit that you take out in the future.
Increased financial stress
Rising interest rates can increase the financial stress felt by any borrower. When you have a variable-rate loan, you have to worry about the impact on your monthly payments. If you’ve been saving up to buy a house, it might push your timeline back because you will need to save more money to afford the future monthly payments. Buying a house also includes additional costs like homeowners’ insurance, which can be affected by rising interest rates too. All this uncertainty of interest rate changes is sure to weigh heavy on a borrower’s shoulders.
How do rising interest rates affect the cost to borrow?
When the federal government increases interest rates, borrowing money becomes more expensive overall. Whether you have car loans or a credit card, you can expect to pay higher borrowing costs to the financial institution you are working with.
Higher interest rates on new loans
Increased interest rates affect all new loans, not just variable-rate loans. When interest rates rise, all new interest rates will rise as well. That means while you may already have a mortgage pre-approval with an interest rate of 3.0%, if the bank or credit union raises its interest rates by 2.6%, you could find yourself paying an interest rate of 5.6% when you finally sign papers.
How you can protect yourself
There are steps you can take to minimize the financial stress that comes along with high interest rates. Generally speaking, sticking to fixed-rate loans as much as possible can help protect you from financial hardships if interest rates skyrocket. Variable-rate loans can be tempting because they often have a lower interest rate than fixed-rate loans. The problem is that there’s no guarantee that low interest rates will stick around for the lifetime of the loan. Even if you have a lower payment at the beginning of the loan, you might end up paying far more interest throughout the lifetime of the loan.
If you already have a loan with a variable rate, it’s not too late to make a change. You could apply to refinance the loan with a fixed-rate loan and lock in a rate to keep your monthly payments from changing.
You might want to consider making extra payments toward your principal balance when possible. Not only will this help you repay the debt quicker, but it can also lower the total amount of interest that you’ll end up paying.
No matter what type of personal finance product you’re looking for, it’s always a good idea to shop around and compare your options. Interest rates can vary between products and between financial institutions.
You might find that you’re eligible for a lower interest rate by keeping all your personal loans with the same financial institution. You could also find that some financial institutions have found ways to cut their own costs and pass the savings along to their members.
Continue to stay informed
Staying informed about changes to the average interest rate is essential. These changes impact both new loans and existing loans, so it’s important even if you don’t plan to borrow money any time soon. Not only will it enable you to be proactive with your money but it will help you make an informed decision.
When the time is right for you to buy your dream home or purchase a new car, reach out to First Tech Federal Credit Union, and let us help guide you through the process.