Interest Rates are Going Up – Now What?
We’ve all heard discussions recently about inflation, and we’ve all felt it at the gas pump or at the grocery store.
You may have also heard about the corresponding rise in interest rates from the Federal Reserve. Why is that? First, let’s take a look at the relationship between interest rates and inflation, and the role that the Federal Reserve plays in our economy. We will then explore how these interest rate increases will affect you.
Why is the Federal Reserve increasing interest rates?
For several years now, interest rates around the world have been historically low. They were dropped after The Great Recession in 2008-2009, slowly picked back up, and were dropped to nearly 0% during the pandemic. Central banks around the world slash interest rates to help boost the economy. When interest rates are low, that means two things for the average consumer:
- The rate you’re paid on your bank deposits is low.
- Money can be borrowed for a cheap rate.
Economies pick up speed when spending takes place. In order to boost, or “heat up" an economy, central banks will lower interest rates. Consumers are disincentivized to keep cash in the bank (because they earn hardly anything on it) and they’re incentivized to borrow, spend, and invest money in the economy, therefore heating it up. Over time, the economy can become red-hot which can lead to high levels of inflation.
High levels of inflation can be dangerous and unpredictable. Therefore, the central banks around the world want to slow down the pace of inflation to a more sustainable level. Raising interest rates is the main mechanism they use to accomplish this. By increasing interest rates, they’re doing the opposite of what we mentioned above. When interest rates are higher, consumers have more incentive to keep money in the bank (because they’re paid more interest) and it’s more expensive to borrow (because the rates on loans are much higher). Therefore, the rise in rates eventually begins to decrease spending and investment, slowing down inflation over time. These are all parts of a normative economic cycle.
So, how do these interest rates affect you? Here are a few key ways (although there are more):
- If you’re someone who is interested in purchasing a home, your mortgage rate will be higher than it has been in years. The current average rate for a 30-yr mortgage is now over 5%. Due to the increase in rates, your potential mortgage payment can be significantly higher. By saving up enough funds for a down payment or by purchasing a slightly smaller home, you could choose to implement a 15-yr mortgage instead, saving significant amounts of interest over time.
PRO TIP – All types of financing are affected by the rise in rates – not just mortgages!
- We may start to see increases on the rates for bank deposits, CDs, and money market funds. As a general rule of thumb, we always want to have 3-6 months of household expenses set aside in an emergency fund, as well as enough cash for major purchases occurring in the short-term. Hopefully, these funds will start generating more interest (although it could be very slight).
- Bonds will be affected (and already have been). We’ll discuss this in greater length in our next post.
At the end of the day, rising rates can lead to uncertainty and confusion for many people. As always, it’s important to focus on taking an eternal perspective and remembering God’s principles when it comes to money management. They work in every circumstance and situation – including when interest rates go up.