If you’ve been keeping up with the news, you’ve probably been hearing that the Federal Reserve was contemplating increasing interest rates. They finally did so for the first time in a year on December 14, 2016. Raising the federal funds rate could have a lasting impact on the economy and understanding how this policy change might affect you can help you effectively budget for the future.
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What is the Federal Reserve?
The Federal Reserve, also known as the “Fed,” is the central banking system in the United States. The Fed manages the country’s monetary policy, which is one way that the government attempts to control the economy. Our monetary policy has three main goals: maximizing employment, steadying prices and regulating interest rates.
Federal Funds Rate
Let’s talk more about those interest rates. The Federal Reserve has control over the federal funds rate, which is the interest rate used when financial institutions conduct trades with each other. The Fed can increase this rate by decreasing the amount of money in its supply.
A higher federal funds rate makes money scarce and thus it becomes more difficult and more costly to borrow. This increase then trickles through the rest of the economy, from banks all the way down to consumers.
Why the Fed Raises Interest Rates
As you would imagine, higher interest rates discourage borrowing because they make loans more difficult to pay back. They’re necessary, however, when the Fed needs to slow economic growth and inflation. This usually occurs when the market is in good shape.
After the economic crisis in 2008, the Fed reduced rates to record low levels. Years later, the Fed had to decide if our economy was finally doing well enough to consider raising interest rates to more normal levels (that is, above a near-zero rate).
The Fed had played coy and kept discussing, but delaying, the planned increase. In June 2015, chairwoman Janet Yellen said that the plan is to raise interest rates before the end of the year. On December 16th, they did, from a range of 0% to 0.25% to a range of 0.25% to 0.5%.
Related Article: How Rising Interest Rates Impact Buying vs. Renting
How This Increase Affects You
But will this affect you at all? Absolutely. A federal funds rate increase will impact many facets of everyday life.
If you’re a saver, you’ll rejoice in the news of an interest rate hike. If you’re a borrower or an avid investor in equities, this may not be the best news for you.
1. Headed to the Bank?
That may not be a bad idea. Interest rate hikes incentivize bank deposits because when interest rates are higher, you receive a greater return on your investment.
Say you have $40,000 in the bank. If the interest rate on a savings account is 0.25%, you’d only make $100 on that $40,000. Compare that to a 1.5% interest rate, where you’d receive $600 for that $40,000. It adds up!
2. Loans Become More Costly
When interest rates creep upward, borrowers experience the opposite effect that savers do. What do buying a home and purchasing a new car have in common? Getting a loan for both become more expensive as interest rates go up.
Compounded over time, higher interest rates will result in you owing more to your lender. It’s no wonder that refinances become more popular when news of an interest rate hike breaks, as homeowners attempt to lock in lower rates for their mortgages before they start climbing higher.
3. Stocks vs. Bonds
Having trouble choosing an asset to invest in? An interest rate hike could help you make that decision. Bonds are safer investments to make, but stocks have the potential for much greater returns due to their greater inherent risk.
But a higher interest rate means that you could receive a higher return on your bond. Especially for the risk-averse, investing in bonds often becomes an attractive option in the face of an interest rate increase.
Related Article: How Rising Interest Rates Affect Retirement
The moral of the story is that when the Federal Reserve adjusts interest rates, the average American feels the effect. No matter which direction it’s moving in, it’s important to know how an interest rate adjustment will affect your personal finances. That way, you can budget appropriately for years to come.
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