Federal Reserve Rate Hike Winners and Losers
How to Benefit from Federal Reserve Rate Hikes
The Federal Reserve began raising interest rates on December 15, 2015. It plans to keep increasing rates into 2019. In this rising rate environment, there will be some winners and some losers.
How fast will interest rates rise? The Federal Open Market Committee raised the fed funds rate by a quarter point at its December 19, 2018, meeting. The current fed funds rate is 2.5 percent. The Committee is encouraged by steady economic growth, positive jobs reports, and a healthy inflation rate. As a result, it will further increase this interest rate to 3 percent in 2019.
How do these rising interest rates affect you? It depends on whether you are a saver or a borrower. An increasing fed funds rate improves returns on savings accounts, money market accounts, and certificates of deposit.
Loans are a little different. Only adjustable-rate loan interest rates are determined by the fed funds rate. These include auto loans, adjustable-rate mortgages, and credit cards.
On the other hand, rates on long-term loans and mortgages follow the 10-year Treasury yield. As the economy improves, demand for Treasurys falls. Investors are willing to put their money into riskier stocks and bonds to get higher returns. As a result, Treasury yields rise to attract more buyers. Higher Treasury yields drive up interest rates on long-term loans, mortgages, and bonds.
Savings Accounts and CDs
All holders of savings accounts and certificates of deposit are winners. Those interest rates track the London Interbank Offer Rate. That's the rate banks charge each other for short-term loans. Libor is usually a few tenths of a point above the fed funds rate. Savings accounts follow the one-month Libor rate, while CDs follow longer-term rates.
It's worth your while to find the best savings account interest rates. Small banks and credit unions can offer higher rates because they have lower costs. Even if they don't have physical banks in your area, you can do all your banking online.
Since rates are going up, you may not want to lock your money into a CD that is longer than six months. You would miss future rate hike increases.
Money market funds offer slightly higher rates than savings accounts or CDs. They invest in the money market instruments offered only to businesses. They also invest in U.S. Treasurys and CDs. They are very safe most of the time. The only time they weren't was during the financial crisis. Businesses began pulling out their funds, forcing the federal government to step in and guarantee them. The best money market rates require a minimum deposit.
Those who have large outstanding balances on their credit cards will lose from the fed rate increases. Banks base their credit card rates on the prime rate. It's what they charge their best customers for short-term loans. It's three percentage points higher than the fed funds rate.
Banks can charge anywhere from 8 percent to 17 percent more than the prime rate for credit card rates. Those with good credit scores pay the lower rates, while those with poor scores pay the higher rates. Banks also charge different rates depending on the type of card.
The best way to become a winner is to pay off outstanding credit card debt. Once that's done, only charge what you can afford to pay off each month. You can also transfer that debt to a zero-interest credit card for a small fee.
Adjustable Rate Loans
The fed funds rate guides adjustable rate loans. These include home equity lines of credit, interest-only mortgages and any other variable rate loans. Interest on your outstanding loan balance will rise soon after the FOMC raises the rate.
The only way to be a winner on these loans is to pay them off or refinance into a fixed-interest loan.
Most auto loans are from three to five years with fixed interest rates. Any holder of a fixed rate loan is a winner. Those rates don't follow the prime rate, Libor, or the fed funds rate. Instead, they are about 2.5 points higher than one, three, and five-year Treasury bill yields. Yields are the total return investors receive for holding the bills.
The U.S. Treasury sells Treasury bills, notes, and bonds at an auction for a fixed interest rate. Investors can sell them on the secondary market. Many other factors influence their yields. These include the demand for the dollar from forex traders. When demand for the dollar rises, so does demand for Treasurys. Investors will pay more to buy them. Since the interest rate doesn't change, the overall yield falls.
Demand for Treasurys also increases when there are global economic crises. The U.S. government guarantees repayment. As a result, interest rates on long-term debt only loosely follow the fed funds rate.
Mortgage Rates and Student Loans
Banks set fixed rates on conventional mortgages a little higher than the yields on 10, 15, and 30-year Treasurys. Interest rates on long-term loans rise along with those yields. The same holds true for student loans. Mortgage interest rates have a tight relationship to Treasury note yields. As a result, all fixed-rate mortgage and student loan holders are winners.