Debt is a common reality for many people, but interest rate hikes can make it even harder to manage. As interest rates rise, the cost of borrowing money increases, and this can have a significant impact on your financial situation. Whether you have a mortgage, credit card debt, or a personal loan, understanding how interest rate hikes work and how they can affect your debts is essential for managing your finances effectively. Interest rates are set by central banks, such as the Federal Reserve in the United States, and are used to manage the economy. When the economy is growing too quickly, central banks may raise interest rates to slow down spending and prevent inflation. Conversely, when the economy is struggling, central banks may lower interest rates to encourage spending and investment.
The Federal Reserve raised its benchmark interest rate by a quarter percentage point on Wednesday. This move marks the eighth hike since March 2022, as the Fed is trying to bring down inflation that is still running near its highest level since the 1980s. Despite some recent signs of slowing, inflation remains elevated, so the Fed sees the need for “ongoing increases in the target range.” The Fed has been reducing its bond portfolio holdings, resulting in a reduction of about $445 billion since June. The market is watching for where the Fed will finally end the interest rate increases, with some betting it will be closer to 4.75% and that the Fed will start cutting rates later this year.
How do rate hikes affect your debts?
Interest rate hikes can have a direct impact on the amount you pay each month on your debts. For example, if you have a fixed-rate mortgage, the interest rate you pay will not change during the life of the loan. However, if you have an adjustable-rate mortgage, your interest rate can change based on market conditions. When interest rates rise, your monthly mortgage payment will also increase, making it more difficult to manage your other debts. Similarly, if you have a credit card or personal loan with a variable interest rate, your monthly payments will increase as interest rates rise. This can make it more difficult to pay off your debt and can increase the total amount you will pay over time.
Mortgage rates over time
The current landscape of mortgage interest rates is best understood through an examination of historical trends in 30-year fixed rates over the past five decades. In recent times, the average 30-year rate has remained relatively stable, with a range of approximately 3% observed in 2021 and early 2022. However, as the Federal Reserve continues to raise interest rates, it is likely that mortgage rates will follow suit, leading to increased costs for home purchases and potential impacts on the stability of the housing market.
Below is the 30-year fixed rate average of last 10 years:
The Federal Reserve Bank of St. Louis has documented fluctuations in mortgage rates over time, including the 1981 period when high rates of over 18% were a result of the Federal Reserve’s efforts to combat inflation through interest rate hikes. Conversely, the 2008 financial crisis saw a reduction in mortgage rates to historical lows as the Fed implemented rate cuts aimed at stimulating the economy. These shifts in mortgage rates have substantial implications for housing affordability and present challenges for both existing homeowners and prospective buyers.
Managing debts amid rising interest rates
As interest rates rise, it becomes increasingly important to consider how they may impact personal loans and mortgages. Fortunately, there are several measures that individuals can take to minimize the impact.
Evaluate financial situation, debt level, and expenses
Prior to securing a personal loan or mortgage, it is crucial to assess one’s financial situation, including income, expenses, and debt level. This information can assist in making informed decisions about the loan amount and type of loan that is most suitable. For instance, if an individual has a $4,000 monthly income, $3,500 monthly expenses, a $400 car payment, and $800 credit card debt, their debt-to-income ratio would be 43% ($1,200 debt / $4,000 income). This high debt-to-income ratio may affect loan approval and it may be wise to focus on paying down debt before taking on more debt to improve the ratio and increase the chances of loan approval with a favorable interest rate.
Consider a fixed-rate loan
A fixed-rate loan offers stability and predictability, as the interest rate remains unchanged for the life of the loan. This is in contrast to a variable-rate loan, which has an interest rate that can fluctuate based on changes in the market, such as changes in the Federal Reserve’s interest rate. Choosing a fixed-rate loan protects against interest rate hikes and the resulting increase in monthly payments and total loan cost. For example, if an individual took out a $250,000 mortgage with a 5-year adjustable-rate loan at 3.5%, and interest rates rose after three years, their monthly payments would increase by $250. If they had chosen a fixed-rate loan at 4%, their monthly payments would have remained the same, resulting in a total savings of $15,000 over the remaining five years.
Build an emergency fund and stick to a budget
Developing an emergency fund can help to mitigate the impact of higher monthly payments due to interest rate hikes. It is also essential to stick to a budget to manage expenses and ensure that one has enough money to cover monthly payments. For example, a 35-year-old teacher with a $50,000 yearly salary, $15,000 credit card debt, and $1,500 monthly rent, with $2,000 left after expenses, may consider a $15,000 fixed-rate personal loan with a 3-year term and 5% interest, resulting in a $450 monthly payment that is affordable for their budget. The fixed-rate ensures stable monthly payments and protects against interest rate hikes.
Refinancing to lower monthly payments and total loan cost
Refinancing involves taking out a new loan to pay off an existing one and can be a good option for those who wish to lower their monthly payments or reduce the total cost of their loan. Shopping around for the best rates can lead to a refinancing option that best fits one’s financial situation. However, it is important to keep in mind that refinancing may have costs, such as closing fees, so it is essential to factor these into the pros and cons of refinancing. For example, if an individual refinanced a $200,000 mortgage at 7% interest with 20 years left to a 15-year loan at 4% interest, their monthly payments would decrease by $225 and the total cost of the loan would decrease by $36,000. After paying $2,500 in closing fees, their total savings would be $33,500.
Interest rate hikes can have a significant impact on your debts, but there are steps you can take to manage the increased cost of borrowing. From reviewing your budget and financial goals, to refinancing your mortgage or consolidating your debts, there are strategies that can help you navigate your debts in the age of interest rate hikes. By being proactive and taking control of your finances, you can ensure that you are in a better position to manage your debts and achieve your financial goals.