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How Does the Federal Reserve’s Tightening of Credit Affect Me?

August 3, 2022

Ephraim Fishman, CPA

This past Wednesday, the Federal Reserve moved to further tighten credit by raising its benchmark interest rate by a sizable 0.75 percentage point for a second straight time. The central bank is aggressively raising borrowing costs to try to slow spending, cool the economy and defeat the worst inflation in four decades. The Fed hopes that by making borrowing more expensive, they will slow demand for homes, cars and other goods and services. Reduced spending would then curb inflation. Yet, there is the risk that these higher rates could tip the U.S. economy into recession, which could bring higher unemployment, rising layoffs and further downward pressure on stock prices.

 

This fourth raise in rates since March will affect borrowing costs for homes, cars and credit cards, though many borrowers may not feel the impact immediately. Many consumers and businessowners are wondering – how will this increase in rates impact my finances and my business?

 

Will the increase in rates affect mortgage rates?

 

It’s important to note that mortgage rates don’t necessarily move in tandem with the Fed’s increases. Sometimes, they even move in the opposite direction. However, the Federal Reserve controls the prime rate, which is the rate that banks borrow from one another. As the cost of funds increases, rates to the consumer will subsequently rise as well, since the banks need to make a profit. In addition, long-term mortgages tend to track the yield on Treasury notes, which, in turn, are influenced by a variety of factors. As the Fed hikes rates to combat inflation, Treasury yields rise as well. Investors’ expectations for future inflation and global demand for U.S. Treasuries will also affect the yield on Treasury yields. The average 30 year mortgage rate has increased from 3.10% at the end of 2021 to 5.30% as of July 28th, 2022.

 

Will it be easier to find a house?

 

Higher interest rates have torpedoed the housing market. Because of the increases in home loans, sales of existing homes have dropped for five straight months, while new home sales plunged as well. If you’re financially able to go ahead with a home purchase, you’re likely to have more choices than you did a few months ago, although your monthly mortgage payment will be higher due to the increased rates. In many cities, for the past two years, options were few, and bidding wars were common for existing homes on the market. But the number of available houses nationwide has started to rise after falling to rock-bottom levels at the end of last year. According to the National Association of Realtors, homes available for sale are up 2.4% from a year ago.

 

Will the increased rates affect business loans?

 

Many businesses have revolving lines of credit with a bank that incur interest pegged to the prime borrowing rate. There is a direct correlation between the increases in the fed’s rate with prime. As prime goes up, the cost of borrowing money increases. For all of 2021, the prime rate remained stagnant at 3.25%. Due to the increases in 2022, prime is now 5.50%. The significant increases in rates will have a negative effect on a company’s bottom line. As an example, if a business has a revolving credit line that averages $10,000,000, the company’s borrowing costs will increase from $325,000 when rates were 3.25%, to $550,000 if rates remain at 5.5%, an increase of $225,000. With the feeling that rates will continue to rise, the increased cost of borrowing will be an issue for many companies.

 

I need a new car and will be financing my purchase. Will the increase in rates affect my payments?

 

The Fed’s rate hikes typically make auto loans more expensive. However, other factors also affect the cost of financing a new car, including competition among auto makers and the purchaser’s credit rating. In addition, the slowdown in manufacturing due to the worldwide shortage of computer chips has caused a backlog in production. Due to supply and demand, prices have risen and automakers are reluctant to offer incentives and price reductions. With the higher costs, many drivers are holding on to their cars longer, causing a shortage of used cars, driving up their prices as well. If you are in the market for a car, you should expect to pay more, and increases in rates will make the monthly payments even higher.

 

What will happen to my credit card and home equity payments?

 

For users of credit cards, home equity lines of credit and other variable-interest debt, rates will continue to rise by roughly the same amount as the Fed hike, usually within one or two billing cycles. That’s because those rates are based in part on the banks’ prime rate, which moves in tandem with the Fed. Consumers will be stuck paying higher interest on their balances. According to LendingTree, the Fed’s rate increases have already sent credit card borrowing rates above 20% for the first time in at least four years.

 

Will the increased rates affect my savings?

 

On a positive note, people can now earn more on bonds, CDs, and other fixed income investments. However, it depends on where your savings are parked. Savings, certificates of deposit and money market accounts don’t typically track the Fed’s changes. Instead, banks tend to capitalize on a higher-rate environment to try to boost their profits. They do so by imposing higher rates on borrowers, without necessarily offering any higher rates to savers.

 

Online banks and high-yield savings accounts are often an exception. These accounts are known for aggressively competing for depositors. As the Fed increases their rates, banks are more willing to offer a higher yield to attract depositors. The only catch is that they typically require significant deposits.

 

If you have any specific questions pertaining to the increases in the Federal Reserve’s interest rates, and how it affects you and your business, feel free to reach out to your LMC professional.

 

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