Credit Repair

What Happens to Credit When the Fed Changes Rates?

If your credit card company has ever sent you a letter saying your interest rate is going up, you might have wondered what you did wrong. But unless you were overdue on your payments or experienced a significant change in your financial situation, chances are your interest rate change had nothing to do with you.

The Federal Reserve — the central bank of the United States — sets a target interest rate for the country, known as the federal funds rate, that it can adjust periodically to guide the economy. While interest rates on credit aren’t equal to the federal funds rate, they are usually tied to it. This means that when rates are falling, you may want to opt for variable-rate loans, and when they’re on the rise, a fixed rate could save you money. Let’s take a closer look at how to manage your finances when the Fed changes rates.

What happens to credit card rates when the Fed tightens?

The federal funds rate has been on the rise since 2016. Rising rates are often a sign of a healthy economy, but they do increase the cost of borrowing money. This can put a strain on your finances if you’re paying off debt or shopping for loans.

Short-term credit with a variable interest rate tends to track the federal funds rate most closely. This means that as a revolving line of credit, credit cards are usually first to go up with increases in the federal funds rate. Though these increases are small and incremental, you could see your credit card rates go up almost immediately after an increase from the Fed.

What to do if the Fed keeps raising rates

“If interest rates are heading up, the best strategy is to reduce debt in accounts that can increase in cost,” said Mike Sullivan, director of education at Take Charge America, a nonprofit financial education organization. In other words, you want to pay off balances that have variable interest rates, such as credit cards and adjustable-rate loans. Here are some tips.

Consolidate high-interest credit cards with a fixed-rate loan. “The best way to avoid debt problems is to pay off debt,” Sullivan said, “but the next best approach is to pay less in interest.” If the Fed is set to continue rate hikes in the future, Sullivan said it might be time to take out a fixed-rate personal loan to pay off your credit card debt. Rates on fixed-rate loans stay the same for the life of the loan, even as the Fed rate increases. However, you want to do this only if you can qualify for a lower interest rate, so you’ll need to have a good credit score. If you’re a homeowner, Sullivan recommended considering a home equity loan. These loans use your house as collateral, so they typically have lower interest rates than credit cards and might be easier to qualify for. But keep in mind that if you go with a home equity loan, you are putting your home at risk; you could lose your house if you are unable to make your payments.

Consider refinancing adjustable-rate loans into fixed-rate loans. If you’re dealing with adjustable-rate loans, such as adjustable-rate private student loans or adjustable-rate mortgages (ARMs), you can consider refinancing them with a fixed-rate loan. Again, the goal is to save money on interest, so you don’t want to refinance at a higher rate. If you can get a comparable or lower interest rate by refinancing, securing a fixed rate will ensure that your loan doesn’t get more expensive over time.

Pay off credit card debt. Fixed-rate loans aren’t the only way to pay off credit card debt. If you’re extremely disciplined, consider paying it off using the avalanche method, which focuses on paying off your highest-interest balances first. If you need some extra motivation, the snowball method, which focuses on bringing your smallest balances to zero first, may be more your speed.

What to do if the Fed lowers rates

“Interest rates on loans always go down more slowly than they rise,” said Sullivan. “It seldom pays to bet on falling interest rates.” He warned consumers against moving debt every time there’s a slight decrease in interest rates, as this action usually involves costs and risks. However, if rates are declining significantly and you have debt or are considering borrowing, you might save money with the following tips.

Consider adjustable-rate loans. If you’re thinking about taking out a loan when rates are falling, you might want to opt for adjustable over fixed-rate loans. Locking in a fixed rate while rates are still high means you may not be able to take advantage of lower rates in the future. While adjustable-rate loans (such as ARMs) don’t offer the stability of a fixed-rate loan, they do tend to come with lower interest rates to start.

Refinance existing higher-rate debt. Even if you went with a fixed-rate loan, you can always refinance existing debt at a lower rate if interest rates have gone down significantly. Refinancing, which is common with mortgages and student loans, simply means taking out a new loan for your existing debt with better terms. This option is worth considering if you have good credit or can improve your credit first.

What credit score do you need to get good interest rates?

A FICO Score of 720 or above is usually enough to qualify for the best rates, according to Sullivan. However, that threshold can drop or rise by up to 30 points in different economic environments.

Once your score falls below 700, though, you’ll start to see a bump in rates. If your score is below 600, Sullivan said, you’ll be considered subprime and have to pay very high interest rates, so you might want to consider repairing your credit before borrowing money. On the other hand, if you’re stressed about having a perfect credit score, you can probably relax a little. “A score of 850 will not get you a better rate than a 799,” he said.

The bottom line

Put simply, when interest rates are on the rise, fixed-rate credit is usually smarter. When they’re declining, adjustable-rate credit could save you money. Avoid high-interest debt altogether, and if you already have it, prioritize paying it off as quickly as possible. Regardless of changes in interest rates, it’s always possible to manage credit wisely.


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