What Rising Interest Rates Mean for You
The current Federal Reserve funds rate as of August 2022 is 2.25%. This is the interest rate commercial banks need to pay when they borrow money from the Federal Reserve. When banks have to pay higher rates to borrow money this trickles down to us consumers. When we borrow money from a bank to buy a car or a house, we have to pay a higher interest rate to the banks. Here’s how this post is broken down:
- Why are interest rates going up
- What do higher interest rates mean for us?
- What we can do to reduce our interest rates
Why are interest rates going up?
Interest rates are a method used by the Federal Reserve to maintain price stability: when everyday things we buy start getting too expensive, a phenomenon called inflation, the Federal Reserve raises interest rates to reduce demand and money velocity. All of this is in the hope of slowing inflation.
What do higher interest rates mean for us?
When we need to buy something and don’t have enough cash to buy it outright, we have to borrow money from a bank or a lender. We then have to pay the money we borrowed back, plus an extra amount called “interest.” The interest we pay is compensation to the lender for giving us the money today and expecting repayment sometime in the future.
Let’s say we need to borrow $500,000 in a 30-year fixed interest rate loan to purchase a home. Here’s how our monthly mortgage payment will look with different interest rates.
| Monthly Mortgage Payment on a 30-year fixed $500,000 Loan | |
| Interest Rate | Mortgage Payment |
| 2.00% | $1,848 |
| 3.00% | $2,108 |
| 4.00% | $2,387 |
| 5.00% | $2,684 |
| 6.00% | $2,998 |
| 7.00% | $3,327 |
| 8.00% | $3,669 |
When the interest rate on mortgages goes from 2%, what it was around 2020-2021, to 5%, the current mortgage interest rate, we would have to pay about $800 more per month on a $500,000 30-year mortgage. That’s about $9600 more per year for the same house.
Let’s say you wanted to buy, or lease, a new car. Higher interest rates will also mean you will have to pay more per month for the same car. For example, buying a brand new Honda Civic for $25,000 with a 60-month auto loan would cost you the following per month assuming a $0 down payment:
| Monthly Payments for a $25,000 Honda Civic with $0 Down | |
| Interest Rate | Car Payment |
| 2.00% | $438 |
| 3.00% | $449 |
| 4.00% | $460 |
| 5.00% | $471 |
Notice that because the loan for a car is smaller ($25,000 for a car versus $500,000 for a home) and the loan term is shorter (60 months for a car versus 30 years for a home), the monthly payment doesn’t go up by as much as the interest rate rises.
What can we do to reduce our interest rates?
The more we borrow and the longer we borrow, we will end up paying more as interest rates increase. In order to reduce how much extra we pay as the Federal Reserve increases interest rates, we either need to reduce how much we borrow or shorten the time we ask to pay off the loan amount.
- In the case of a home purchase, you can decide to go for a 15-year home loan instead of a 30-year home loan to reduce interest rates. Furthermore, you can look to either refinance your home after getting a variable interest rate loan. Variable interest rate loans typically have a lower starting rate than longer-term fixed-rate loans.
- Shop around and seek out various lenders to try and get lower interest rates. Most times, smaller banks and credit unions offer lower interest rates than large, commercial banks.
- In the case of cars, homes, or anything, we can consider putting more as a down payment. Having a larger down payment can reduce how much we end up paying in interest because we reduce the starting loan amount.
- If inflation doesn’t slow down, the interest rates can reach double digits as they did during the 1970s. If that’s the case it will be very expensive to borrow money and we would have to consider buying in all cash instead.