How Fed Rate Hikes Impact Borrowers
The Federal Open Market Committee (FOMC) is expected to raise its benchmark interest rate by 25 basis points, to a range of 2.25-2.50%. This is the 9th rate increase by the Fed since 2015 as it unwinds policies put in place to address the financial crisis and recession from 10 years ago. Recent market turmoil has called future rate hikes into question, but we believe a growing economy will lead to at least two rate hikes in 2019. The increase in the short-term borrowing rate will affect interest rates on a variety of financial instruments.
The impact on mortgage rates can be ambiguous
Although there is often a misconception that changes in the federal funds rate affect mortgage rates, this is not the case. Case in point: In the last three Fed rate-hiking cycles (since 1994), the Fed funds rate increased 3 percentage points on average, and the change in mortgage rates was muted at an average 1 percentage-point increase. At times, mortgage rates were even falling as the Fed funds rate increased, as it happened early this cycle from 2015 to 2016.
Although the Fed funds and mortgage rates are often influenced by the same factors, that is not consistently the case, and they are rarely impacted to the same extent. The U.S. Treasury and mortgage markets operate independently of the Fed funds rate and are also influenced by international developments and investors to a larger extent, further decoupling them from the Fed funds rate impact.
Mortgage rates, particularly fixed interest rates, are determined by the supply and demand for longer-dated securities. In this regard, another action the Fed is taking does have an impact on mortgage rates. The Fed’s plan to normalize its balance sheet by lowering holdings of treasuries and mortgage-backed securities reduces demand for these longer-dated securities and will apply some upward pressure on interest rates over time.
Thus, the balance sheet reduction is more important than the federal funds rate itself. To help recovery from the financial crisis, the Federal Reserve grew its balance sheet by purchasing treasuries and mortgages to keep interest rates low; this was known as quantitative easing. The Fed believes the economy is stronger now and needs less support, and thus began reducing its balance sheet in September 2017. No change is expected in the future path of balance sheet normalization.
The real impact will be seen in variable-rate products
Adjustable-rate mortgages and home equity lines of credit are based on short-term rates, which will be impacted by the increase in the Fed funds rate. The prime rate is a bank lending rate set as a spread to the Fed funds rate. It will increase with the Fed hike, and since most HELOCs are tied to this rate, borrowers will see immediate increases in their interest rates. Another reference rate is the LIBOR rate; it does not have as direct a relationship, but will often move in tandem with and in anticipation of increases in the Fed funds rate. Many adjustable-rate mortgages are tied to LIBOR rates. Borrowers with outstanding ARM loans will see their rates increase at the annual reset, and rates for new ARM loans will also increase as the market anticipates further rate hikes.
Keep in mind that lenders don’t raise rates at the same pace — consumers should shop around to mitigate the impact of rising rates on their cost of borrowing.
Here’s how the Fed rate hike will impact some loan products:
Expect rate hikes on both private variable-rate and fixed-rate student loans. Most private student loans use a version of the LIBOR index, which fluctuates with the market. Anticipated changes in Fed interest rates (among other factors) are usually already “baked in” to the LIBOR rates. This means that if the market believes rates will generally trend higher, LIBOR will rise in a commensurate fashion. Private student loan rates will thus already be seeing increases, even before a Fed announcement. They will continue to rise if investors expect further increases in the Fed funds.
Rising rates also have an impact on fixed-rate loans, including fixed-rate student loans. Fixed rates available for new student loans will increase as underlying rates increase. However, once a fixed-rate loan is originated, the rate won’t rise. For new federal loans, rates are set using the 10-year Treasury rate each spring.
Credit card debt will immediately become more expensive. Those in credit card debt will typically feel the impact of rising interest rates immediately in the form of rising APRs. Credit card interest rates track the bank prime rate, defined as 3% above the Fed funds target rate. The prime rate will thus move up immediately, with the Fed funds target and credit card rates that reference it, increasing as well.
Interest rates on auto loans are less influenced by the changes in the Fed funds rate. New cars are often financed by the auto manufacturers, and the interest rate is a part of the entire car-buying transaction. Thus, auto manufacturers frequently offer discounted financing to encourage car sales, and banks and other lenders compete with those rates. Interest rates on auto loans can be influenced by 10-year rates due to their 5+year terms in many cases.
Rates on deposits have been increasing over the past year, though not to the extent that the Fed funds rate has increased. Many banks can offer little or no interest, which enables them to increase the amount of interest they earn. There is more variation in deposit interest rates than with other products; banks will often raise lending rates immediately while holding back on increasing deposit rates until forced to do so to attract deposits.
Financial institutions will make adjustments at different paces and to a different extent for these products, related to the varying business strategies they may have. Consumers should review their accounts to ensure they still serve them in the best way.