What a Fed Reserve Rate Increase Means

Published on December 13th, 2016

What Does a Federal Reserve Rate Increase Mean?

As I’m writing this, the Federal Reserve Board Open Market Committee is expected to raise the rate (Fed Funds Rate) that is charged for overnight borrowing.  The expected rate increase will be only the second increase of rates in the past ten years, with the last increase being last December.

What does this mean to the average consumer?  For most consumers, the Fed Funds Rate has no direct impact.  Indirectly, there is an impact because there is a rate that is all but tied to the Fed Funds Rate and that is the Prime Rate of Lending.  Most people know this as simply “Prime Rate” or just “Prime.”

Prime is three percentage points (3%) above the Fed Funds Rate and moves synchronously with the Fed Funds rate.  The Prime Rate is important to consumers for a couple of reasons.  Consumers are probably most familiar with the Prime Rate due to Home Equity Line of Credit loans or “HELOCs.”  These types of loans have a variable rate of interest that is typically tied to the Prime Rate.  As this rate increases, the payments on these loans will typically get recalculated and the payment is going to go up accordingly.  Since this is only the second increase in the last 10 years, it may be something for which consumers are not ready.

The second reason that consumers may be aware of the Prime Rate is due to their credit cards.  A majority of credit cards have variable rate interest that is also tied to Prime with a significant margin added on top of the Prime Rate.  My fear for the average consumer is that they are not aware of the variable nature of their credit cards and will not be ready if there is a steady increase in rates over the next couple of years.  I’m not worried about the current expected increase of a .25%.  That shouldn’t affect consumers very much.  However, if there is a gradual rising of rates and cardholders aren’t ready for it, they could run into some significant problems.  I’m not certain that this will happen, but there could be trouble if it does happen.

My concern for many cardholders is that when their credit card rates increase, they may not be aware of the increase because the monthly payments are based off of the credit card balance, not the rate, so the payments won’t change significantly.  Therefore, since the interest rate is higher, more of the payments will be going to interest and not to paying down the principal on their cards.  Without knowing it, the average consumer will be paying less down on their cards each month and could get into debt trouble without being aware of what’s going on until it’s too late.

What’s the alternative for consumers?  On the credit card side there are options for fixed rate credit cards.  You will have to do some comparison shopping to find a card that is fixed with a good rate and rewards program, but that can be found.  Admittedly, I’m biased, but the first place I would look to is your local community or work-based credit union. 

On the Home Equity Line of Credit side, there is less that you can do there, especially if you want to retain your credit limit and your ability to draw funds from your line.  But, if you’re past your draw period or just really concerned with the rate increase, there is the possibility of refinancing a HELOC into a closed-end fixed rate loan.  The refinancing of home equity loans may also come with fees and closing costs.  As a result, you’ll have to review those costs and see whether or not it’s worth it to refinance in order to get the certainty of a fixed rate loan.  It depends on the loan and the financial institution as to what fees and costs may be involved.  Do your homework carefully. 

I love getting feedback on my columns!  If you have any comments and/or questions, please write me at david.lukas@leydencu.org.

 David Lukas

Leyden Credit – President/CEO

 


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