The Federal Reserve may be poised to raise interest rates this month—nearly one year after the first interest rate increase following the Great Recession. But if the central bankers at the Fed do decide to raise interest rates at the meeting on December 13 and 14, it probably won’t be by very much. Federal funds rate futures are forecasting a hike of about one-quarter of one percent.
The federal funds rate is the short-term interest rate controlled by the Fed and is currently aimed at a rate from 0.25% to 0.50%. A rate increase could put the new target rate from 0.50% to 0.75%, still low by historic standards.
Though the Federal Reserve controls only very short-term interest rates used by financial institutions, the move has implications across the economy—and may directly affect the interest rate your savings and investments earn and the price you pay to borrow money. Here’s how it works and what you can do.
Earn more on savings and investments.
If you have a savings account or a money market account at a bank, you’ve probably despaired over the incredibly low interest rate your savings have earned since 2008. That’s when the Federal Reserve took drastic steps to try to pull the economy out of a recession by slashing interest rates. With rates at historic lows, the interest paid on deposits fell to record-breaking lows and stayed there.
When the Federal Reserve raises interest rates, however, banks typically follow that by also raising the interest rates paid on customer accounts. That means you will likely see slightly higher rates of interest on certificates of deposit and savings accounts. After many years with interest rates essentially at zero, many savers will be happy with any increase.
What you can do: In general, a rising rate environment is good for savers. Who wouldn’t like to earn a higher rate of interest on their cash? You may be able to take advantage of higher rates by seeking out high-yield CDs or high-yield checking or saving accounts. One thing to beware of is inflation—parking a large sum of money in a relatively low-yielding account for several years could lead to a loss of purchasing power over time.
Savers with a long time until they need to use their money may want to consider looking for higher-yielding saving options or investment products, including stocks and stock mutual funds or ETFs. A large sum of money in a relatively low-yielding account could lose purchasing power to inflation over time. But remember, there are tradeoffs. To get higher yields you may need to sacrifice liquidity (the ability to quickly access your money) or accept higher potential volatility (greater swings, higher or lower, in the value of your account).
- Read Viewpoints: “Four ways to earn more on your savings” on Fidelity.com.
What about bonds?
Bonds have a more complicated relationship with interest rates than a savings account does. That’s because many things can influence bond yields. Interest rate moves by the Federal Reserve have historically had one of the largest impacts.
New bonds: After the central bank raises interest rates, new bonds may reflect higher interest rates than those issued before the rate increase. That’s good for bond investors interested in purchasing new investments.
Existing bonds: When market interest rates increase, the price of existing bonds may fall. That means that if you own a bond, the price you could sell it for could be less than face value. If you hold it to maturity, you would experience no loss—you would receive all promised interest and principal payments as agreed, unless the issuer defaulted.
The reason the price goes down is that bonds issued after the rate increase come with a higher interest rate than that of the older bonds. Investors have a choice—they can buy a new bond with a higher interest rate or they can buy your old bond that has the lower interest rate. In order to make an old bond comparable to the new issue, the value of the old bond goes down. It’s said to trade at a discount to the face value.
If the Federal Reserve lowers interest rates, your existing bond may be worth more than freshly issued bonds. That’s because it would have a higher interest rate than a bond issued after interest rates fell. In this case, you could potentially sell your bond for more than the face value—it would be trading at a premium.
What you can do: Interest rates and the economy are out of your control. Your asset allocation should be determined by your long-term goals, tolerance for volatility, and financial situation. It’s important to understand all the risks in your investment mix and invest in a way that lines up with your ability to withstand those risks and achieve your long-term goals.
You may pay more to borrow.
After rates go up, the good news is that your savings may earn more interest. The bad news is that you may have to pay more to borrow money.
Interest rates on variable-rate credit cards increase right away following a rate increase by the Federal Reserve. That’s because the rate on credit cards is typically tied to the prime rate. The prime rate moves up and down with the short-term rate set by the Fed.
What you can do: Though rising interest rates in the economy will probably hit your wallet to some degree if you’re a borrower, your credit score will also play a dominant role in the interest rate you pay—at least for the foreseeable future. That’s because borrowers with the best credit scores get the lowest interest rates from lenders. If lenders see you as a bigger risk due to a relatively lower credit score, they may charge you more to borrow money. To manage the cost of interest, it’s always best to pay credit cards off as soon as possible.
The other thing you can do is make sure that your credit is in good shape. Always paying your bills on time can help you avoid negative marks on your credit report. Try to limit your debt levels as well. For instance, use only a small portion of the credit extended by lenders rather than charging up to your credit limit can potentially. Borrowing responsibly—and sparingly—could help improve your credit score.
Not all loans are directly tied to the Fed funds rate the way credit cards are. But interest rate moves by the Federal Reserve can still affect them. That’s because raising short-term interest rates makes it more expensive for banks to do business. Because they pay more to borrow money, they raise prices on the products they offer—like home or car loans.
When it comes to mortgages, each basis point paid in interest (a basis point is one one-hundredth of one percent) adds up as you may be borrowing hundreds of thousands of dollars for decades. When deciding if you can afford to buy a house or whether or not to lock in a mortgage rate, the interest rate environment may be a concern.
What you can do: While you can’t control inflation and the Federal Reserve, you do have some control over your credit score—and your down payment. Bringing a big down payment to the table can lower your borrowing costs—particularly if you can put down 20% to avoid paying private mortgage insurance.
- Read Viewpoints: “How much house can you afford?” on Fidelity.com.
No matter when the central bank raises interest rates, working to save money, pay off debt, and improve your credit score always pays off.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917