The US Federal Reserve has spoken. For the first time in nearly a decade, policymakers have boosted key short-term interest rates. Now that the deal is done, it is time for you to start looking at your interest-rate policy, too.
Banks, having read the signals, were quick to respond. Within hours, Wells Fargo became the first in a steady parade of US financial institutions to boost their own prime lending rates, with those increases taking effect on Thursday last week. The best customers at banks like JPMorgan Chase, KeyCorp, SunTrust, PNC, Citibank, Wells Fargo and many others now pay a base rate of 3.5 percent for their consumer loans, instead of the 3.25 percent that has been in effect for the past seven years.
By historic standards, that is still cheap. For most of the past two decades, prime lending rates have hovered between 5 percent and 10 percent, and as recently as 2007 topped 8 percent, but after such a long period during which lending rates have not budged an inch, any change is bound to come as a shock — especially when it is simply the harbinger of more profound changes still to come.
Illustration: Mountain people
The rate increase announced by Federal Reserve Chair Janet Yellen and her colleagues last week will not be an isolated event, as they made clear in their statement after wrapping up their meeting and announcing their decision. By the end of next year, they expect the federal funds rate to be at about 1.375 percent, up from its new range of 0.25 percent to 0.5 percent.
That means that we need to brace ourselves for at least four more interest-rate increases next year — and four more opportunities for lenders to make all forms of consumer debt more costly.
This time around, banks and other lenders have had plenty of time to prepare for a single, very small rate increase. Speculation about the first post-financial crisis rate increase has been swirling around the financial markets throughout the year and debt markets had already priced in much of the movement. When Yellen made the much-telegraphed announcement — having previously done everything except hire the Goodyear blimp to warn us all what was coming — the US stock market even staged a brief, day-long rally.
However, going forward the uncertainty will be greater and each rate increase will be that much more burdensome, both for consumers and for the economy as a whole. So, while there is no reason to panic about what modestly higher interest rates might do to your financial situation, or to financial markets, there is a good argument for using the coming weeks to prepare yourself for what is coming.
First of all, you will need to accept the reality that the cost of your debt is going to rise more rapidly than the income you get from your savings. That might seem counterintuitive, since both what you owe in the form of loans and what you receive in interest on debt is tied to the interest rate.
Usually, banks raise interest rates in order to attract cash in the form of deposits, but right now they are pretty flush with capital and do not need to attract much more — they are already wondering how to lend out what they already have in a prudent manner. That means there is little incentive for them, at this early stage in the game, to move rapidly to pay more interest on savings accounts as the Fed raises rates.
Studies suggest that this has been true historically, too — the reluctance on the part of banks to match Fed interest rate increases promptly with offers of higher interest rates to depositors might have cost the latter as much as US$100 billion annually during periods when the Fed was boosting rates.
You can start shopping around for better options on both savings accounts — currently averaging a mere 0.1 percent, a fifth of the level back in 2006, according to Bankrate — and certificates of deposit (CDs).
Yields on a one-year CD average only 0.3 percent, down from 4 percent in 2006. The larger a deposit you are able to make — and in the case of a CD, the longer the time period you are able to tie up the money for — the higher the rate you are likely to find. If you are looking for a high-yielding savings account, your best bet might be an online bank that compensates for its lack of physical presence — and the convenience that offers and that many customers still value — by offering some of the best interest rates on savings accounts.
Still, your ability to capture any upside from higher interest rates is going to be limited by the willingness of financial institutions to pass along those benefits in the form of higher-yielding investments.
It is true that new CDs issued in the coming months likely will offer more appealing rates. The problem? If you need to cash out an existing CD in order to move capital into one of those higher-paying products, you will likely face much greater penalties designed to prevent you from doing precisely that.
While you will want to keep scrutinizing the landscape for opportunities that present themselves in the next few months, your priority needs to be on the risk side of the ledger. That is because, as the prompt action of the banks with respect to their prime rates demonstrated, financial institutions will move more rapidly to make the costs of auto loans, credit-card borrowing, home equity lines of credit, mortgages and other loans more costly.
If you have got an adjustable-rate mortgage that has an annual readjustment feature, you really should be talking about refinancing your mortgage into a fixed-rate structure before the impact of a series of rate increases begins to take its toll. Anyone with any kind of floating rate debt should evaluate their financial situation, calculating not only what they can afford to pay at today’s interest rates, but if interest rates rise a full percentage point between now and the end of next year.
One of the contributing factors in the mortgage crisis that began in 2007 was the fact that too few people understood how much they would have to fork out every month on their adjustable-rate mortgages when interest rates rose. Still, before making the switch from variable to fixed interest rates, check to see it makes sense, given your balance and the time remaining on the loan, since fixed interest rates tend to be higher.
Look for ways to shift debt into lower-cost structures. In the case of credit-card users, that might mean seizing 0 percent introductory rates offered by card issuers to new customers with good credit ratings. If you are a disciplined borrower and know you will not load up your cards with fresh spending — and you are in a financial position to do so — you might be able to take out a home equity line of credit or other bank loan at a lower interest rate than your credit cards are offering and use the proceeds to pay off the balance on your cards.
The ripple effects will take months to show up. Federal student loans reprice in the summer, for instance, and by July next year they will undoubtedly be pricier. By then, private student loans already will have registered the impact of higher borrowing costs, since their interest rates are linked closely to short-term interest rates.
Fed policymakers have told us what they are going to do next. It is up to us to listen and prepare as best we can.
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