Having waited years for the economy to show signs of sustained strength, the Federal Reserve now looks determined to keep raising interest rates in 2018 in order and bring them back closer to historical norms.
While nobody can predict the Fed’s next move, most members of the Federal Open Market Committee indicated they expect to follow this week’s 0.25 percentage point increase in the federal funds rate with at least two more increases in 2018. But nearly as many think three additional increases may be warranted this year, which would bring the benchmark short-term rate up by a full percentage point this year, to 2.5 percent.
The Fed has to walk a careful balancing act: Raise rates too slowly, and not only could inflation take off, but policymakers will have little room to lower rates to stimulate the economy if it crashes again. Raise them too quickly, and the Fed could derail the ongoing recovery.
“In making our policy decisions over the next few years, we will continue to aim for inflation of 2 percent while sustaining the economic expansion and a strong labor market,” Federal Reserve Chairman Jerome Powell said Wednesday. “In the Committee’s view, further gradual increases in the federal funds rate will best promote these goals. By contrast, raising rates too slowly would raise the risk that monetary policy would need to tighten abruptly down the road, which could jeopardize the economic expansion.”
Upcoming meetings where rate increases are most likely to be announced are June 13, Sept. 26, and Dec. 19.
That’s got anyone who’s thinking about buying or refinancing a house, borrowing for college, or paying off credit card debt wondering whether it’s going to cost them a whole lot more.
Interest rates for many credit cards and variable-rate student loans are commonly indexed to the prime rate or LIBOR. So if you’re concerned about what’s going to happen to the interest rate on your existing credit card debts or variable-rate student loans, keep watching the Fed.
If you’re more concerned about what it’s going to cost to take out or refinance student loans or a mortgage six months or a year from now, you’ll want to join the crowd that’s keeping a close eye on long-term rates — 10-year Treasury yields in particular.
Here’s a quick overview of what you need to know.
- Credit cards: Rates on credit card debt are typically tied to indexes that track the Fed’s moves closely. One option for borrowers carrying balances: consolidate credit card debt into fixed-rate personal loans.
- Student loans: While rates on federal student loans are fixed for life, rates for new borrowers are adjusted annually. So students taking out loans for this fall can expect to pay higher rates than in recent years.
- Mortgages: If the Fed keeps raising short-term interest rates, mortgage rates may follow, but not as rapidly. Fannie Mae projects that rates on 30-year fixed-rate loans will rise modestly this year and stabilize in 2019. Borrowers with variable-rate loans can lock in today’s rates by refinancing into fixed-rate loans.
The first thing to keep in mind is that even though the Federal Reserve has a firm grip on short-term interest rates, mortgages and other long-term rates often have a mind of their own.
That’s because long-term rates are largely determined not by the Fed, but by investor demand for safe investments like Treasury bonds and mortgage-backed securities.
The chart below illustrates the way yields on 10-year Treasurys often anticipate the Fed’s monetary policy moves, but don’t always move in lockstep.
While the Fed was pulling monetary policy levers to keep short-term rates at zero percent from 2009-2015, yields on 10-year Treasurys went on a kiddie coaster ride, as investors fretted over whether the economic recovery was real or not.
In the chart above, recesssions are represented by a gray band. After the 2008 recession, investors kept expecting the economy to spring back to life. But every setback sent them running back to the safety of bonds, pushing long-term rates down.
Having kept short-term rates on the floor for what seemed to many like a freakishly long time in order to encourage borrowing, the Fed is finally seeing growth in the economy, jobs, and wages that could allow it to bring rates back up without tanking the recovery.
After getting off to a false start at the end of 2015, the Fed has been on a gradual, sustained rate-hike kick, bumping short-term rates up by 0.25 percentage points five times since December, 2016. Wednesday’s increase brought the federal funds rate — the interest rate banks charge each other for short-term loans — to 1.75 percent.
The last time the Fed embarked on a sustained rate hike, bringing the federal funds rate up by more than 4 percentage points from 2004-2006, long-term rates only budged slightly.
If you’re in the market for a mortgage, keep an eye on 10-year Treasury yields. Investors view mortgage-backed securities as a very similar investment to Treasurys. So mortgage rates track 10-year Treasurys pretty closely — although the “spread” between them can increase when mortgages seem riskier.
So the takeaway for anyone in the market for a mortgage is this: If the Fed keeps raising short-term interest rates, mortgage rates may follow, but not as rapidly.
Complicating the equation is the fact that when the economy tanked in 2008, the Fed bought up truckloads of Treasurys and mortgage-backed securities that it’s now in the process of unloading, which could contribute to pressure on long-term rates.
Economists at Fannie Mae have put a lot of thought into where mortgage rates could be headed next year. In their latest forecast, issued on March 19, Fannie Mae economists see rates on 30-year fixed rate mortgages rising just 0.3 percentage points this year, from 4.2 percent to 4.5 percent.
Next year, Fannie Mae forecasts that mortgage rates will essentially remain flat, at 4.6 percent (those rates are reserved for well-qualified borrowers putting down sizable down payments).
To put that in context, let’s say you’re making a 20 percent down payment ($48,340) to buy a median-priced home for $241,7000. You’d need a $193,360 mortgage. If you were able to take out a 30-year fixed-rate mortgage at 4.2 percent, your monthly payments will be about $946 a month. If the best rate you can get two years from now is 4.6 percent, you’re looking at a monthly mortgage payment of $991 — about $50 more than today.
The total interest payments you’d make over 30 years would increase by more than $16,000 — from $147,000 to $163,500. But keep in mind that it’s rare for homeowners to stay put for 30 years. Historically, six years to nine years is more typical. But since interest eats up more of your monthly payment in the early years of a loan, most of those costs would be incurred on during the first half of your repayment term.
Over six years, you’d pay $4,520 in additional interest for the loan with the higher interest rate, and $1,280 less principal, for a net cost of $5,800 — about $1,000 a year. Over nine years, you’d pay in $6,766 in additional interest, and pay down $1,831 less principal, or $8,597 in additional costs.
So while mortgage rates are worth keeping an eye on, would-be homebuyers might think twice about buying a house that will stretch their finances just because they’re eager to lock in a mortgage at today’s rates.
Borrowing for college
For anyone wondering how Fed rate hikes will affect the cost of borrowing for college, the story will play out much the same as it does for mortgages. That’s because rates on government student loans are indexed to 10-year Treasury notes.
Once you take them out, rates on federal student loans are fixed for life. But every year on July 1, the Department of Education adjusts rates on loans to new borrowers to reflect the government’s cost of borrowing.
As the chart below demonstrates, rates on federal student loans went up last year for the first time since 2014, and are probably headed up again for borrowers attending school next fall.
If you want to be the first to know what rates on federal student loans will be next fall, you’ll want to keep your eye on an auction of 10-year Treasury notes scheduled to be held on May 9. That’s because the yield on those notes will serve as the base rate for federal student loans taken out between July 1, 2018 and June 30, 2019.
When last year’s auction was held, yields on 10-year Treasury notes were 2.4 percent — an increase of 69 basis points (or 0.69 percentage points) from the year before. The Department of Education takes the yield from the May auction and tacks on different additional margins for loans to undergraduates, graduate students and parents.
With 10-year Treasury yields currently hovering around 2.8 percent, students headed to school this fall would be see rate increases of about 0.4 percentage points if the auction were held today.
Students who have several years of classes ahead of them before they graduate might see rate increases each year they’re in school. Again, while it’s a good idea to keep an eye on the situation, there’s no need to panic. Fannie Mae economists currently see little pressure on long-term rates next year, and are forecasting 10-year Treasury yields will remain stable at 3.0 percent throughout 2019.
But even if Treasury yields stabilize, students returning to school in the fall of 2019 will be looking at taking out federal loans at rates that are nearly 1.3 percentage points higher than in 2016 (see chart below).
An undergraduate paying back $30,100 in student loan debt on the standard 10-year repayment plan would rack up $8,300 in interest charges at the projected 2019 rate for undergraduates (5.05 percent). That’s $2,240 more than if they’d been able to take out all their loans at the rate in effect for the fall of 2016 (3.76 percent).
Graduate students relying on costlier federal direct loans for graduate students could soon be looking at interest rates approaching 7 percent. A grad student leaving school with $30,100 in undergraduate loans and another $46,000 in grad school debt could be looking at $25,260 in total interest costs, an $5,812 increase from 2016 rates.
Interest rates on PLUS loans for parents and grad students could soon climb to nearly 8 percent, particularly if factoring in the 4.26 percent upfront fee charged by the government the to calculate the annual percentage rate (APR) on PLUS loans.
A parent repaying the average federal PLUS loan debt of $10,226 would be saddled with $4,393 in interest payments at the projected 2019 rate of 7.6 percent, an increase of $813 from 2016 rates.
And what if forecasts by Fannie Mae and other economists predicting only modest increases in long-term rates turn out to be wrong? How high could rates on federal student loans go?
When Congress decided to tie rates on federal student loans to 10-year Treasury yields — a system in place since 2013 — lawmakers also set some upper limits. Rates on federal student loans to undergraduates can’t exceed 8.25 percent. The cap is 9.5 percent for graduate loans, and 10.5 percent for PLUS loans.
Private student loans and refinancing
While rates on federal student loans are fixed for life, many private lenders offer borrowers a choice of a fixed- or variable-rate student loan.
The initial rate on a variable-rate student loan may be lower than what you’d be offered on a fixed-rate loan with the same repayment term. But your rate can rise and fall with the rate that it’s indexed to — most private student loans are indexed to either the London Interbank Offer Rate (LIBOR) or the prime rate, which track the federal funds rate closely.
So if the Fed raises short-term interest rates three times this year, 25 basis points at a time, rates on existing variable-rate student loans will go up by 0.75 percentage points in 2018. Many variable-rate mortgages are also indexed to LIBOR.
Variable-rate mortgages and student loans typically have upper limits as well, which are set by the lender when the loan is originated. With rates headed up, many borrowers will look into refinancing variable-rate student loans and mortgages with lenders offering fixed interest rates.
Borrowers who are carrying balances on their credit cards will also be affected by the Fed’s rate increases, since those rates are often indexed to LIBOR or the prime rate. Like others repaying debt with variable interest rates, many will look to lock in a fixed rate by paying off variable-rate credit card debt with a fixed-rate personal loan.
If you look at the latest numbers on consumer credit from the Federal Reserve, the average interest rate for consumers carrying credit card debt was 14.99 percent at the end of November. The average rate for personal loans with two-year repayment terms was 10.57 percent.
If you’ve got $10,000 in credit card debt at 14.99 percent, it would take you three years to pay it off with monthly payments of $347, and you’d pay $2,478 in interest — even if interest rates didn’t budge.
If you were able to increase your monthly payment to $464 a month and refinance your credit card debt at 10.57 percent, you’d pay it off in two years and save $1,340 in interest payments.
Many borrowers with good credit can qualify for even lower rates.