Rate Hikes: Good for Savers, Bad for Borrowers
Interest rates have been adjusting since the Federal Reserve Board’s decision earlier this month to raise short-term interest rates--for the seventh time in a year. This has a mixed impact on borrowers, investors, savers and consumers of all stripes.
Why have interest rates been rising? Who is hurt or helped? Here’s a look at some basic questions:
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Q: How much have interest rates risen over the last year?
A: Since January, 1994, the prime rate has risen by three percentage points, to 9% from 6%. While the prime is not the only interest rate index, it’s a good indicator of what’s happened to other rates--including mortgage rates.
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Q: Why have rates risen so much?
A: Because of the perceived risk of inflation. After several years of slow growth or none, the national economy started to heat up in late 1993. People started to buy again, which started corporate machinery running faster and sparked price hikes for a variety of goods and services. Commodity prices, particularly, started to rise sharply. Such price hikes, in particular, raise the ugly specter of inflation because it so difficult to replace commodities. The oil price shocks of the 1970s are commonly blamed for igniting the high inflation of that period.
In early 1994, the Federal Reserve began to boost the important interest rates it controls--the rates it charges banks for short-term loans--to slow the economy and fend off inflation.
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Q: How does raising interest rates slow the economy?
A: It makes it more expensive to borrow money for buying things, so consumers can afford fewer items. They buy less and companies sell less, hire less and produce less. The economy, which is largely fueled by consumer spending, begins to slow down.
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Q: Are rising interest rates good or bad for me?
A: That depends on whether you’re a saver or a spender. Borrowers are in for rough sledding. Rates on everything from credit cards to mortgages and home equity loans have risen.
Savers, on the other hand, are in good shape. Interest rates on deposits, money market mutual funds, Treasury bills, notes and bonds are all up sharply. Where investors were hard pressed to earn more than 3% to 5% on safe, fixed-income investments a year ago, now they can easily find returns ranging from 6% to more than 8%, depending on the type and duration of the investment.
Recently, interest rates for the intermediate term--two to five years--have risen faster than long-term interest rates. Economists say this probably reflects the belief that inflation will eventually be less of a problem.
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Q: You say credit card rates are headed upward, but I just got a new card with a 9% rate.
A: Chances are, you got an introductory rate on a floating-rate credit card. Heated competition in the credit card market has made this type of card more widely available. Card issuers are aggressively marketing them to good risks.
Introductory rates are temporary, however. At a set point, disclosed in your credit card contract, the introductory rate will be replaced by a floating rate most likely based on the prime rate plus several percentage points.
A standard deal, for example, is a card rate that floats 9.9 percentage points above prime. In January, 1994, the fully phased-in rate on that card would have been 15.9%; today it’s 18.9%.
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Q: What about my mortgage? I have an adjustable rate mortgage that’s tied to the Treasury bill index. Am I about to get creamed?
A: Not from the most recent Fed hike, but the cumulative effect of the seven interest rate hikes will definitely affect you this year and perhaps next year too.
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Q: What does that mean in dollars and cents? How much are my payments going to rise?
A: If you have a $100,000, 30-year mortgage at 6%, you’d be paying $600 a month in principal and interest. If the rate rises to 8% in 1995, you’ll pay roughly $734 a month. If the rate rises to 9% in 1996--as it may, to account for the full 3 percentage point hike--your payment would rise to about $805.
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Q: I have a fixed-rate loan, so I don’t have to worry about this, right?
A: Right. Unless you were planning to refinance or take out a home equity loan, the recent rate hikes will not affect your mortgage payment at all.
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Q: Will the rate on my home equity loan rise?
A: Yes. Home equity loans are generally tied directly to the prime, which rose to 9% from 8.5% on Feb. 1. So the rate on prime-based home equity loans will rise half a percentage point also. In dollars and cents, the Fed’s latest action would cost $50 a year in additional interest payments for a home equity borrower with a $10,000 balance.
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Q: Will I earn more on my bank deposits?
A: Probably. Banks are slowly raising the rates they pay on deposits, but these rate hikes have been smaller than the rise in prime. That’s simply because deposit rates are based both on market rates and on each bank’s need for funds. Banks are still not desperate for cash to lend, and until they are, increases in deposit interest will be modest.
Additionally, some types of bank accounts are virtually impervious to interest rate changes. Many bank passbook accounts, for example, still pay a paltry 3% return, even though all other interest rates are rising.
If you want higher rates on bank savings, you may have to shift your deposit into a higher-earning account. The good news is that even short-term certificates of deposit are now yielding between 5% and 6% at many banks. Shop around.
