Interest rates drive the way we borrow money and manage our finances. Depending on what kind of market and rate environment we’re in, adapting to how we save, spend, and borrow money is essential to financial success.
Over the last year, interest rates have been steadily on the rise. For money savers with share certificates and savings accounts, it’s an excellent position to be in. Typically, in a rising interest rate environment, financial institutions raise yields in an effort to attract more deposit activity. The higher the yield, the better the earning possibilities. For borrowers in need of lending solutions, it’s the complete opposite, especially when you take the market and type of loan you have into consideration.
Rate increases can significantly influence our economy and affects the way we manage our budget and finances. So, it’s critical to understand the different types of loans and their intricacies and what’s best in an unpredictable economy.
How do Federal Funds Affect Interest Rates?
Within the last couple of years, you’ve undoubtedly seen countless news headlines that refer to the Federal Reserve, inflation, the rise of rates, federal funds, and the prime rate. But what exactly does all of that mean and how are they related to one another?
One of the Federal Reserve’s responsibilities is to maintain and promote a strong, healthy economy. And one of their primary objectives is determining the cost of borrowing money. They set a benchmark interest rate, known as the federal funds rate (or fed funds rate). Fed funds are intended to be used as an economic tool that controls financial supply and offsets inflation when the economy is overstimulated. The fed funds rate has an impact on interest rates that banks and credit unions charge for loans. In a thriving economic climate where everything is running efficiently, rates are relatively stable and more attractive to consumers, which may encourage them to borrow money. In an unpredictable economy that’s riddled with uncertainties, interest rates increase at a more rapid pace to make it more expensive for consumers to borrow in an effort to manage inflation.
This sounds exactly like what’s happening now, right? When you really stop and think about the state of our current economy, when was the last time the general public consistently heard about fed funds and rate hikes like this? If you answered with 2008, then you are spot on. In fact, there hasn’t been significant fluctuation with federal funds since then and what was known as the Great Recession. To put this into perspective, from March of 2022 to now, the Federal Reserve has raised the fed funds rate by nearly 5 percentage points. That number, to put it frankly, is astronomical. And it’s had a significant impact on the way consumers bank and borrow money. These rate adjustments have, of course, stemmed from the effects of the pandemic and the impact on the supply chain. Limited supply with high demand creates inflation. Prices rise so that the consumer buys less and the supply chain can catch up. Due to inflation and high rates, the cost of living inevitably increases, and borrowing money to finance your home, vehicle, education, and purchases you make on a credit card become that much more difficult, especially depending on the type of loan you have.
What is a Fixed Interest Rate?
A fixed rate loan is a type of loan where the interest rate remains the same for the entire length, or term, of the loan. Once you close on your loan, your interest rate cannot change. Since the interest rate cannot change on a fixed rate loan, borrowers can expect their monthly payments to remain the same throughout the lifetime of the loan.
Unlike a variable rate loan, fixed rate loans do not fluctuate based on market conditions. The only time, if applicable, that your interest rate can change is if you have the ability to refinance your loan for a better, lower interest rate.
Fixed rate loans are the ideal choice for borrowers that crave predictability. There aren’t any surprises with this type of loan. You can confidently borrow money knowing that your interest rate will remain the same for the lifetime of the loan despite what may be happening in the economy and market. For instance, take auto and home equity loans into consideration for a moment. Most auto loans and home equity loans offer a fixed rate, so whether it’s your first or twentieth payment, your payment and rate will remain unchanged, so you’ll always know how much to budget.
What is a Variable Interest Rate?
A variable rate loan is a type of loan where the interest rate varies; the rate fluctuates because it’s dependent on market interest rate changes. Variable interest rates are typically found in loan products such as mortgages, lines of credit, and credit cards.
Variable rate loans follow economic trends. The biggest advantage with this loan type is found during a declining interest rate market. If rates are declining, then your monthly loan payment and loan rate will more than likely automatically follow suit and decline as well, thus saving you money.
In a rising interest rate environment, like the one we’re in currently, borrowers will find that the opposite happens and see their loan rates and monthly payments increase. So, to put it in perspective, let's say you’ve got a variable rate credit card with a current APR of 10%. If the prime rate increases by 0.25%, then your rate will likely increase to 10.25% APR.
Which Choice is Best?
So, which is the better choice: a fixed rate loan or variable rate loan? Well, it truly depends on market conditions and the interest rate environment. And I think it’s safe to say that we’re all very aware of where the market’s at right now.
Let’s say you’ve currently got a variable rate loan. Pre-pandemic, variable rates were an extremely attractive financing option for borrowers. The rates were super low, and there weren’t many significant increases. But nowadays and since variable rates loans are tied to the prime rate, the rate increases have been pretty consistent, and may leave you cringing and wondering how you’re going to afford your monthly payments if all this keeps up.
Should you jump ship? Will rates keep going up? When can we expect rates to stabilize? Should you hit the pause button on pursuing your financing needs? Believe me, these are all great questions, and with inflation still lingering, significant rate cuts may not be in the near future for us. Although, with that being said, the Fed has certainly slowed down on how aggressively they’ve been making rate adjustments, which is a good sign. I suppose we’ll all just need to sit tight and see what’s in store next.
In the meantime, if you’re looking for my best advice, here’s what I’ve got. Explore all your options and do your research; shop around, compare rates, and understand the fine print to ensure that you get the best possible rate and term. Be sure to look into alternatives like fixed rate loans and terms to see if they’d be better suited for you financially. If you have an immediate need for a loan and you find rates that are within a reasonable range, I’d suggest taking advantage of it now; rates aren’t decreasing much right now and it may be the prime time for you to borrow.
When you’re ready to lock in on financing at a competitive rate, be sure to keep GOLD in mind. As always, our team is standing by and ready to help you decide on the lending solution that’s best for YOU!