Loan interest

How Inflation Can Affect Your Loan Interest Rates

Inflation is everywhere in the United States right now. The average price of a pound of ground beef increased 16.1% between February 2021 and February 2022, according to the US Bureau of Labor Statistics. Between the fourth quarter of 2021 and the fourth quarter of 2020, the median selling price of homes increased by 13.77%, according to the US Census Bureau and the Department of Housing and Urban Development.

A few different things can affect inflation: the cost of producing something, the growing demand for the item, or even a country’s monetary policy. In addition to directly affecting prices, inflation indirectly influences other things, like the interest rates on the loans you pay.

Here’s what you need to know about the impact of inflation on interest rates for mortgages, personal loans, credit cards and other forms of credit.

Inflation rate vs interest rate

Inflation is a measure used to measure how the cost of goods and services increases over time. It is usually represented by a percentage change from month to month and year to year.

Inflation rates are based on the Consumer Price Index, which tracks a basket of goods and services that a typical household would buy, such as food, fuel, utilities, clothing, healthcare medical, vehicles and more.

Interest rates, on the other hand, represent the cost of borrowing as an annualized rate. Lenders determine the interest rates to charge their customers based on economic conditions, creditworthiness, type of loan and other factors.

How Inflation Affects Interest Rates

Inflation does not directly affect interest rates, but the two are usually correlated through indirect means.

“Prolonged availability of low interest rates can flood the market with additional liquidity as consumers increase their borrowing and spending, ultimately leading to higher inflation,” said David Tuyo II, CEO and Chairman. of University Credit Union in California. “This creates a balance because as inflation rises, interest rates are also likely to rise, which again slows consumer spending and borrowing, and ultimately leads to lower inflation. and standardized standards.”

Here’s a deeper dive into what you need to know.

Short-term interest rate

The Federal Reserve has several objectives, one of which is to maintain a satisfactory level of inflation. To promote stable economic growth, the Fed aims to maintain an inflation rate of 2%.

If inflation levels are too high or too low, the Federal Open Market Committee, an arm of the Federal Reserve, can raise or lower its federal funds rate. This interest rate is what banks charge each other to borrow or lend excess reserves overnight.

The prime rate “moves in tandem with the federal funds rate and affects many loans that are priced based on the prime rate,” says Bob Dieterich, executive vice president and chief financial officer of 1st National Bank of Scotia in New York. .

Specifically, the prime rate is what lenders use to determine interest rates on short-term loans, such as credit cards, student loans, auto loans, personal loans, and variable rate mortgages. .

As the rate of inflation rises beyond acceptable levels, the FOMC may raise its federal funds rate, forcing lenders to raise their prime rates. As a result, consumers are less likely to borrow money. “As the cost of debt rises for borrowers, it slows the economy down,” Tuyo says, which may help temper rising inflation.

On the other hand, if the rate of inflation falls to a level indicating economic stagnation or contraction, the FOMC may cut its interest rates, which ultimately encourages more borrowing, helping to increase consumer spending and growth. economic.

For the past two years, since the start of the coronavirus pandemic, the Fed has kept the target federal funds rate between 0% and 0.25%. Due to the strength of the labor market and growing inflation concerns, the FOMC raised the target range for the federal funds rate by a quarter of a point. Fed officials expect the rate to rise six more times in 2022.

Mortgage interest rate

The FOMC does not set interest rates for mortgages, and although its federal funds rate may impact the variable interest rate of a variable rate mortgage via the US Federal Interest Rate Index short-term interest used by your lender, it does not affect fixed mortgage rates.

That said, fixed mortgage rates are influenced by the 10-Year Treasury, which is a government bond issued by the US Treasury Department with a 10-year maturity. Because it is backed by the federal government, investors view the 10-year Treasury as a risk-free investment.

“When inflation expectations are high, bond buyers bid less on longer-dated bonds,” Dieterich says, “which raises bond rates as well as the mortgages that use them as a pricing basis.”

The average interest rate on a 30-year fixed-rate mortgage began to rise in late December 2021, from 3.05% on December 23 to 4.41% on March 24, according to Freddie Mac.

What this means for you

The impact of inflation on interest rates may vary depending on your current loan types and borrowing plans. Here’s what to expect with different types of credit:

  • Credit card. The vast majority of credit cards have a variable interest rate, which means the rate fluctuates over time depending on the prime rate. You can usually expect your interest rate to change within a month or two of a change in the federal funds rate, and it’s usually in line with the rate change. For example, if the FOMC raises its rate by 0.25, expect that increase in the annual percentage rate of your credit card.
  • Personal loans. In general, personal loans have fixed interest rates, which do not change for the term of the loan. If you currently have a personal loan, inflation will not change your interest rate. However, personal loan companies will likely raise their interest rates for new borrowers within a month or two of a hike in fed funds rates. Therefore, if you plan to take out a personal loan soon, you may have to pay more interest.
  • Lines of credit. If you have a personal line of credit or a home equity line of credit, your interest rate will generally be variable. This means that your interest rate could rise in the weeks following a hike in the fed funds rate. In some cases, lines of credit may allow you to convert part or all of your existing balance to a fixed rate of interest. If so, locking in a fixed rate now could save you money, as the FOMC is expected to raise its rate multiple times throughout 2022.
  • Car loans. As with personal loans, car loans usually have a fixed interest rate, so you don’t have to worry about your borrowing costs increasing on an existing loan. However, increases in the federal funds rate may result in higher auto loan interest rates for new borrowers.
  • Student loans. If you have federal student loans, your interest rates are fixed for the term of the loan, so you don’t have to worry about inflation impacting your rate. However, private in-school student loans and student refinance loans can come with a fixed or variable interest rate. An increase in the federal funds rate will cause your variable rate to increase on an existing loan, as well as fixed and variable rates on new loans.
  • Mortgage rates. If you have a fixed mortgage rate or are in the fixed period of a variable rate mortgage, which can last from one to 10 years, inflation will not affect your current rate. But if you’re past the fixed term on a variable rate mortgage, your rate typically changes every six or 12 months based on the short-term index your lender uses, such as the overnight finance rate. guaranteed. Potential buyers can also expect higher interest rates on new mortgages.

What you can do to fight rising interest rates

If you are concerned about the impact of rising inflation and interest rates on your budget, there are steps you can take to limit their impact on you:

  • Pay off your credit card debt. If you have a credit card balance, make it a priority to pay it off as soon as possible. Tuyo recommends using a personal loan to consolidate your debt and convert it into a fixed interest rate loan. Then, make it a priority to pay your credit card balance on time and in full each month going forward to avoid interest charges.
  • Borrow only when necessary. Rising interest rates can discourage borrowing due to the higher cost associated with lending, and that’s not always a bad thing. If you’re considering taking out a personal loan or using a credit card to buy something you don’t need, it may be worth reconsidering your decision.
  • Refinance your variable rate mortgage. Fixed mortgage rates are already on the rise, but if you stick with your variable rate mortgage, you could end up paying a lot more. Take the time to research your options to determine if refinancing is right for you.
  • Improve your credit. If you’re planning on borrowing soon, consider taking the time to improve your credit score before you apply. Although interest rates generally go up, a high credit score can help you get a lower rate and maximize your savings.

The important thing is to be aware of the impact of your borrowing and spending habits on your financial well-being and to adjust your habits according to economic conditions.