Rising interest rates can affect the household budget

Raising interest rates is one of the most powerful inflation-fighting weapons that the Federal Reserve has in its economic control arsenal.

And as the Fed tries to reduce the rate of inflation without sending the United States into a recession, it's a good time to review the importance of interest rates and how they work. The Federal Reserve has seven more meetings this year at which it can take action on interest rates, with the next one scheduled for March 22.

What is the Federal Reserve's current interest rate?

At its last meeting on Feb. 1, the central bank raised interest rates a quarter of a percentage point to 4.75, where it remains. The current interest rate is the highest it has been in 15 years.

The increase was also the eighth consecutive time the Fed had increased interest rates.

Here's what is affected

Interest rate hikes increase the cost of borrowing across a wide variety of consumer loan products like credit cards, mortgages and home equity lines of credit as well as auto and school loans. As the interest rate increases, consumers see the amount they pay increase.

John Carusone, president of the Bank Analysis Center, a Hartford-based industry consulting firm, said the interest rate the Fed sets is the starting point for how banks and other consumer lenders set the rate that they charge consumers.

"It's designed to reflect the cost of credit, which includes the cost of having enough money to loan, the operating expenses of the lender and the potential for increased risk of consumer loan delinquencies or defaults," Carusone said.

Donald Klepper-Smith of South Carolina-based DataCore Partners said current data on auto loan delinquencies best illustrate the risk component for lenders.

"The percentage of loans 30 days past due is closing in on 10 percent," Klepper-Smith said.

Carusone said another factor built into the interest rate that consumers are charged is the bank or lender's desire to increase profits

"They do it because they can," he said.

So although the interest rate set by the Fed is currently at 4.75 percent, once all those components are added in, Carusone said, a hypothetical interest rate for a consumer could be 7.5 percent or more.

Which consumers are hit hardest

Frank Chen, an associate professor in the accounting and finance department at the University of New Haven's School of Business, said any increase in interest rates hits two groups the hardest: Home mortgage holders with adjustable rate mortgages, home buyers who are considering getting that type of loan and individuals with credit cards whose credit scores are at 660 or lower.

Chen said home mortgages account for about 70 percent of combined household debt, which makes interest rate increases especially problematic for mortgage holders with adjustable rate home loans.

Consumer interest in adjustable-rate mortgages has been growing since the start of the pandemic in March 2020. With rising real estate prices making homeownership more difficult, adjustable interest rates accounted for 10 percent of all new home loans as of the middle of last year after being as low as 3 percent just two years earlier, according to data from the Mortgage Bankers Association.

Adjustable rate mortgages typically have a low introductory rate, which means more affordable monthly mortgage payments initially. With this type of home loan, the initial interest rate is fixed for a period of time. Once that period ends, the interest rate applied on the outstanding balance changes at yearly or sometimes even monthly intervals. Sometimes, adjustable rate mortgages have caps that limit how much the interest rate or loan payments can increase every year or over the life of the loan.

Chen said many credit card interest rates are often high to begin with. Since credit card interest rates are often adjusted when the Fed raises interest rates, consumers with low credit scores end up paying interest rates well above what a credit card holder with a better score would pay, he said.

Why the Fed increases rates

By increasing interest rates, the Fed reduces the supply of money in the economy that is available for borrowing, which makes it more expensive for consumers to borrow money. Because borrowing is more costly, consumers rein in their spending, which in turn drives down interest rates, according to Klepper-Smith.

"Fed policy is trying to restrict inflationary pressures using its controls of the money supply," he said. "By increasing what consumers pay for consumer loan products, they are reducing affordability for consumer goods."

What happens after Fed rate hikes

Lenders "are very quick to adjust what they charge" when interest rates are on the rise, Carusone said. But according to Klepper-Smith, it takes six to nine months for consumers to feel the full impact of a Fed rate increase.

Klepper-Smith said he expects rates to increase by another percentage point before the end of 2023.

"We're going to see a topping out this year," he said.

Carusone said he expects interest rates to increase by another 1.5 percent over the next 12 months.

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