Inflation has remained persistently high longer than the Federal Reserve anticipated. This is due to a confluence of factors, including labor shortages, supply disruptions, insatiable consumer demand, and low interest rates, among other things.
One of the weapons in the Federal Reserve’s arsenal to combat inflation is the power to raise interest rates. Although interest rates have not increased yet, analysts are expecting multiple rate increases in 2022. If interest rates do go up, what does that mean for you?
Who is affected by higher interest rates?
An interest rate increase directly affects only borrowers and lenders—specifically, only new borrowers or debt that has a variable interest rate, which is tied to interest rate changes. This would include new home mortgage loans, credit cards, and new business loans.
The cost for borrowers increases, and because of that, the revenue for lenders increases as well. Higher interest rates are usually a net negative for borrowers and a net positive for lenders.
An important note is that if you already have a fixed interest rate, this will not change even when interest rates increase. Most people opt to go with a fixed-rate mortgage. The downside is that the quoted interest rate is higher than an initial variable interest rate. However, you are insulated because if interest rates increase, your rate won’t go up. That is an enormous benefit of choosing a fixed-rate mortgage over a variable-rate one. If you have a variable-rate mortgage or an outstanding balance on a credit card, those rates can, and usually do, increase when rates go up.
A fixed-rate mortgage can be impacted by a higher rate if you choose to refinance. When you refinance a mortgage or other forms of debt, the rate is going to be based on prevailing interest rates at the time. If rates have increased, your new rate will likely be higher than your previous one. This is why borrowers flock to refinance when rates decrease and usually do not when rates go higher.
How does raising interest rates help curb inflation?
While interest rates only affect borrowers and lenders directly, there are ancillary effects that ripple throughout the entire economy. That is why the ability to raise and lower rates is so powerful.
The main driving factor of interest rates is its impact on demand. As discussed before, interest rates are a net negative on borrowers, and when borrowing costs increase, borrowers are less likely to borrow as much, if at all. A new car at 0% interest for five years is much more appealing and more affordable than borrowing at 5%. As the previous example shows, the cost of borrowing can have an enormous impact on the demand of everyday consumers.
Beyond consumers, borrowing costs affect businesses drastically as well. Many businesses borrow money to expand operations and grow the company. When borrowing costs are low, the prospective return on investment on a future project does not need to be as high because the cost and risk of pursuing it are lower. When borrowing costs are higher, the return on a future project also needs to be higher to compensate for the additional costs and risks of the project.
The price of a product or service in an efficient market is determined by the equilibrium price where the supply and demand curves intersect. As we’ve seen from the examples above, increasing interest rates helps quell some demand because the cost of buying something on credit increases. When demand decreases and supply remains the same, the price of a product or service decreases, or at least won’t be increasing quite as rapidly. This is how raising interest rates can help reduce rampant inflation.
The Federal Reserve has great power with its ability to raise interest rates, but this power is a double-edged sword. While raising interest rates can help reduce inflation, doing too much too quickly can stifle economic growth. If borrowing costs get too high, businesses may no longer wish to expand or hire. Previously planned projects may stop, and with it, the supply of products and services may be reduced. Consumer demand may plummet. Economies may stall. Maintaining an appropriate interest rate environment is a balancing act, and while it’s a powerful tool, it is not always a silver bullet solution. There are certainly serious risks involved that must be managed delicately.
Should you be worried?
We believe in focusing on the things you can control. Unless you are planning to borrow money in the near term, rising interest rates won’t impact you directly. If you are planning to borrow money soon, such as for a new home or car, then rising interest rates may impact your budget.
Just because rates may be rising does not mean it is in your best financial interest to rush out and buy a new home just to lock in these currently low rates. Rushing into any buying decision is rarely prudent. If rates do go up, it will be important to reevaluate your budget and the increased costs. But don’t go out and buy a home (the largest asset most people own) just because of the prospect of rising rates.
As we talked about previously, the idea behind raising rates is to cool off some demand. One of the hottest markets right now is the housing market, especially in New England. Higher rates may mean reduced demand, and with it, the prices of homes may come down or will stop increasing as fast. Although this is not guaranteed by any means, the positive price impact for buyers may more than make up for the increased borrowing costs.
Of course, these higher borrowing costs will only affect people who need to borrow to buy a home. If you already own a home and are looking to downsize or make a lateral move, you likely won’t need to borrow any money, so a change in interest rates won’t affect you.
Conversely, higher interest rates are generally a benefit to savers. Currently, savings accounts are paying next to nothing. Much of the rates these accounts pay are based on prevailing interest rates. If rates increase, the rate savings accounts pay should begin to increase as well.
Savings accounts are a terrible place to keep large amounts of money for a long period of time because of inflation. Even in “good” times, savings accounts rarely keep up with the rate of inflation. The most recent inflation data recorded inflation at 7%. Savings accounts are currently paying almost nothing. So, for simplicity’s sake, if you earn nothing (0%) on your savings account, your money is losing 7% from inflation just for sitting there! If rates go up and accounts start paying 1% and inflation comes down to the long-term average of around 3%, you’re still losing money to inflation, but not nearly as drastically as in the current environment.
This is why with either scenario, we advocate investing with a long-term focus. Although past performance does not guarantee future results, historically, over the long term, the stock market has not only kept up with but exceeded inflation. But pretty much everyone needs some cash set aside in a safe, easily accessible place. If interest rates increase, the money you keep in a savings account for a rainy day won’t be eroding nearly as quickly.
It’s been a while since we last saw the potential for interest rates to increase. Rates were just starting to go up for the first time in years before the coronavirus pandemic derailed those plans. Although borrowing costs will increase, ideally, it will help temper the inflation that we’ve all been experiencing recently.
Increased interest rates directly affect only those who are borrowing or lending. However, higher rates will have an impact on the entire economy and the supply and demand of the products and services we use. Time will tell how much and how quickly the Federal Reserve will raise interest rates and what effect that will have on inflation and the economy as a whole. But this is outside of what we all can control. It isn’t something we should worry about, so we should focus on our overall financial plan and goals, because that’s something we can impact.
If you need help with your financial plan, please reach out to our team.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisor.