Interest Rates Are Heading Up. What Will It Mean For Your Wallet?

Interest rates began rising toward the end of last year and are expected to continuing going up incrementally throughout 2015. Here’s a primer for anyone wondering what they can and should do about rising interest rates.

Why do interest rates go up or down? Interest rates are essentially the price of money or, conversely if you’re talking about your investments, how much you get paid to invest. Without it, people would not be willing to lend or even save their cash, both of which require deferring the opportunity to spend in the present.

As such, interest rates move up and down, reflecting many factors. One such factor is government monetary policy. If the government loosens monetary policy, this means that it has “printed more money.” Simply put, the Central Bank creates more money by printing it. This makes interest rates lower, because more money is available to lenders and borrowers alike. If the supply of money is lowered, this tightens monetary policy and causes interest rates to rise. The U.S. Federal Reserve in particular accomplishes this though government-backed securities. These investment instruments can be bought or sold, depending on what the Fed decides. To lower interest rates, it buys a lot of securities, infusing the banking system with cash. With more money available, interest rates decrease. To raise interest rates, it sells securities. Governments alter the money supply to manage the economy, a constant balancing act. The federal funds rate is what banks charge one another for short-term loans. The Fed can adjust this and the discount rate, which is the interest rate it charges banks for loans obtained directly from the Federal Reserve.

Another factor influencing interest rates is simply supply and demand In a period when many people are borrowing money to buy houses, banks and trust companies need to have the funds available to lend. They can get these from their own depositors. The banks may pay 6% interest and charge 8% interest on a five-year mortgage. If the demand for borrowing is higher than the funds they have available, they can raise their rates or borrow money from other people by issuing bonds to institutions in the “wholesale market.” This source of funds is typically more expensive causing interest rates to go up. If the banks and trust companies have lots of money to lend and the housing market is slow, borrowers financing a house may get “special rate discounts” and lenders will tend to be very competitive, keeping rates low. In a booming economy, many firms need to borrow funds to expand their plants, finance inventories, and even acquire other firms. Consumers might be buying cars and houses. These keep the demand for capital at a high level, and interest rates higher than they otherwise might be. In a nutshell, when more people want to borrower and/or loan money is scarce, lenders can charge higher interest.

And risk is a factor. The interest rate charged to a particular borrower also reflects the risk that the particular borrower might default on the loan. Likewise, rates may be higher due to regulatory interference or economic factors which make the environment at a particular time perceived to be more or less risky for lenders.

What kinds of impacts do rising interest rates potentially have on average folks? If the real interest rate is low, the costs of living, doing business and investing are also low. This stimulates the economy because home and car loans are more affordable. If people can borrow more, they'll spend more. Low real interest rates also generally weaken the dollar, which (in the short term) can be a good thing. When the dollar is weak, foreign goods are more expensive, so Americans tend to buy American-made goods. This stimulates the economy even further because high demand for American goods increases employment and wages.

Changing the interest rates can help fight inflation. If it looks like inflation will go up in the future, real interest will be set at a higher rate. If a society's demands for a certain good exceed the supply, then the product's price will go up. When inflation increases, economic growth begins to slow. The price of the good increases, and so demand for it wanes. Less demand leads to less production, and eventually, unemployment ensues. To offset inflation, the Fed typically raises interest rates. Since low interest rates generally indicate a weak dollar, the increase in interest rates can strengthen the dollar. High interest rates can attract foreign investors looking for high-yield returns on their investments. This causes more demand for the dollar, which increases its value. Eventually, the increased value of the dollar will ultimately slow foreign investment, since it takes more foreign currency to purchase a dollar. But the flow of investment can reverse. A stronger dollar has more buying power worldwide, which allows Americans to purchase foreign goods and invest in foreign companies. This puts added pressure on American companies to compete with cheaper foreign products. If the companies can't compete, unemployment rates rise and domestic economic growth decreases. Abroad, U.S. exporters' growth may slow, too, since a strong dollar increases prices for American-made goods abroad

Remember, businesses also borrow for future profit. They may borrow now to buy equipment so they can begin earning those revenues today. When rates go up, it costs businesses more and one way or another this higher cost is passed on to all of us as consumers.

What can you be doing now to prepare for rising interest rates? If you’re a business owner, To the extent your business is dependent on credit, your costs are likely to go up. You may want to factor in a net increase in costs. Assess whether your business will allow for a related increase in prices to reflect higher interest rates.Your cost of carrying credit for your customers may increase. It may be time to reconsider your receivables pricing policy. You may actually experience an increase in sales as customers try to access credit while it is still comparatively inexpensive. This may be particularly noticeable with capital purchases this year, as companies seek to access cheap credit. On the flip side, increased borrowing costs may cause a longer term slowing of purchases. More costs, less buying. This is an opportunity for you to consider a pricing strategy aimed at timing an anticipated change in rates. For the same reason your customers may change their buying habits, consider your own purchasing strategy.

For individuals, now is a particularly important time to consider your personal savings and investment strategies. Choose short terms over high yields. Savers typically sock money away in whatever instrument has the highest yield. However, this might not be the best strategy today.

And on the credit side, anyone still in adjustable rate products will want to consider converting those to a fixed rate while rates are still low.

Shari Olefson's picture
Shari Olefson

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