As the Federal Reserve Wednesday announced its largest interest rate hike since 1994, many Americans are left wondering what that actually means and how it will affect them.
The Fed raised its benchmark short-term rate by three-quarters of a percentage point in an effort to counter inflation, which is running at the fastest pace in over 40 years.
America’s rampant inflation is imposing severe pressures on families, forcing them to pay much more for food, gas and rent and reducing their ability to afford discretionary items, from haircuts to electronics.
The central bank of the U.S. — also known as the Federal Reserve — is tasked with maintaining economic and financial stability.
The Fed controls the federal funds rate, which is the basic rate at which banks borrow and lend from each other. When that rate rises, so do consumer interest rates.
Expect to pay more
When the Federal Reserve raises rates, it makes borrowing money more expensive.
This means consumers could see higher borrowing rates on home loans, auto loans and credit cards.
Interest rates: When banks pay more to borrow money, they then charge individuals and businesses more interest on the money that they borrow. So consumers can expect to pay more when asking a bank for cash.
Auto loans: While the Fed’s move may have little impact on the final purchase price of most new cars — which is already being influenced by a lack of supply — it will increase the cost of monthly payments. Without a hefty downpayment, consumers can plan on paying more the longer their auto loan is outstanding. Purchasing too much car might increasingly play a role in a consumer’s decision-making.
Home loans: Mortgage rates are not directly tied to the Fed’s interest rate decisions, according to Bankrate, and haven’t always responded in tandem. Mortgage rates may rise even faster than the Fed is hiking.
Sometimes, they even move in the opposite direction. Long-term mortgages tend to match the 10-year Treasury note, which, in turn, is influenced by a variety of factors.
For now, faster inflation and strong U.S. economic growth are sending the 10-year Treasury rate up sharply. As a consequence, mortgage rates jump.
If you have a mortgage with a variable rate or a home equity line of credit, you are likely to feel a more direct influence of the Fed’s move. These rates are tied to the prime rate, and can rise along with the Fed’s rate.
The record-low mortgage rates below 3% that were reached last year, however, are long gone.
Credit cards: The majority of credit cards charge a variable interest rate based on the prime rate, which is influenced by the Fed’s rate. A good credit score, however, can soften the blow.
These much higher borrowing costs could also last well into the future.
How it works
As money becomes more expensive to borrow, demand for homes, cars and other services should decrease in turn.
The hope is that this decrease in demand or “cooling off” of the economy stabilizes prices for American consumers.
Personal finance expert Dan Roccat said to think of it in terms of a balloon.
“There’s a lot of air in the economy,” Roccat said. “What the Fed is trying to do is slowly take some air out of that balloon before it bursts in order to wrestle this beast that we call inflation to the ground.”
Higher interest rates in essence vacuum extra money out of the U.S. financial system, causing employers and consumers to tap the brakes on their financial decisions, stomping on demand for new investments or goods.
This can have a trickle-down effect on U.S. retail sales as well as job creation.
The silver lining?
The aggressive move Wednesday was a bigger increase than the Fed had previously signaled and is a sign that it is struggling to restrain stubbornly high inflation and that more hikes are to come.
Even higher borrowing rates on the horizon mean consumers planning big-ticket purchases are hurrying to organize their debt and lock in current, lower rates.
Conversely, America’s savers benefit from interest rate hikes.
Banks typically adjust the annual percentages they pay out to consumers in their savings accounts or certificates of deposit (CDs), for example, with a change in interest rates.
Boosting your credit score, paying off high-cost debt and refinancing your current loans at a lower rate, according to Bankrate, can also create more breathing room in your budget as interest rates rise.
It remains to be seen what effect raising interest rates will have on inflation. It’s discouraging news as Americans have been providing critical support to the economy even after a year of seeing prices spiral higher for gas, food, rent, and other necessities.
The Asasociated Press contributed to this report.