What Do Rising Interest Rates Mean for You?

The Federal Reserve recently raised its benchmark short-term interest rate—the federal funds rate—for the first time in a year. It also expects to accelerate further interest rate hikes in 2017.

The federal funds rate is the short-term interest rate that banks and credit unions charge each other when they lend or borrow money that is held on account at the Federal Reserve. The federal funds rate is one of the nation’s most influential rates, so an increase has implications across the economy—and may affect your savings and investments, particularly if you’re invested in UC’s Savings Fund or any of its bond funds.

Here’s what this could mean for you.

YOU COULD EARN MORE ON SAVINGS AND INVESTMENTS

If you have a savings account or a money market account at a bank, you may have been unhappy with 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. You may be able to take advantage of higher rates by seeking out high-yield CDs or high-yield checking or savings 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 high-yielding saving options or investment products, including stocks and stock mutual funds or Exchange Traded Funds (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).

YOUR BOND FUNDS MAY BE AFFECTED

Bond funds have a more complicated relationship with interest rates than a savings account does. That’s because many things can influence bond prices. Interest rate moves by the Federal Reserve have historically had one of the largest impacts.

Perhaps the most important thing to remember is that a bond’s price moves in the opposite direction to its interest rate.

  • New bonds: When the Federal Reserve raises interest rates, new bonds may reflect higher interest rates than those issued before the rate increase. That’s good for bond fund investors, because new bonds your fund manager buys could help increase the average rate of the bond fund’s holdings.
  • Existing bonds: When market interest rates rise, the price of existing bonds may fall. For a bond fund manager, the price you could sell an existing bond for could be less than its face value. Why does the price go down? Bonds issued after the rate increase come with a higher interest rate than that of the older bonds. Fund managers have a choice—they can buy a new bond with a higher interest rate or an old bond with a lower interest rate. To make an old bond comparable to the new bond, the value of the old bond goes down. Of course, if the bond is held to maturity, the fund manager experiences no loss, unless the issuer defaulted.

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

When 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.

Credit cards

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 Federal Reserve.

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. Borrowing responsibly—and sparingly—could help improve your credit score.

Other loans

Not all loans are directly tied to the federal funds rate like 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 or 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.

THE BOTTOM LINE

No matter when the central bank raises interest rates, working to save money, eliminate debt, and improve your credit score always pays off.

In general, the bond market is volatile, and the fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.

Fidelity Brokerage Services LLC, member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917
© 2017 FMR LLC. All rights reserved.
789355.2.0