Soaring Inflation Will Make It More Expensive to Borrow Money

Inflation is everywhere in the US right now. The average price of a pound of ground beef increased by 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 price of home sales 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, increasing demand for the item or even a country’s monetary policy. In addition to directly affecting prices, inflation indirectly affects other things, such as the interest rates on the loans you pay.

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

Inflation rates versus interest rates

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

The inflation rate is based on the consumer price index, which tracks a basket of goods and services that a typical household would buy, such as food, fuel, tools, clothing, healthcare, vehicles and more.

Interest rates, on the other hand, represent the cost of borrowing money as an annual interest rate. Lenders decide what interest rates to charge their customers based on financial conditions, creditworthiness, type of loan and other factors.

How inflation affects interest rates

Inflation does not directly affect interest rates, but the two are generally correlated indirectly.

“The long-term availability of low interest rates could flood the market with extra money as consumers increase their borrowing and spending, which eventually leads to an increase in inflation,” said David Tuyo II, president and president of the University Credit Union in California. “This creates a balancing act because when inflation rises, interest rates are also likely to rise, which slows down consumption and borrowing again, and eventually leads to lower inflation and normalized standards.”

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

Short-term interest rates

The Federal Reserve serves many purposes, one of which is to maintain a satisfactory level of inflation. To promote stable economic growth, the Fed has a target of maintaining inflation at 2%.

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

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

More specifically, the prime rate is what lenders use to determine interest rates on shorter loans, such as credit cards, student loans, car loans, personal loans and mortgages with adjustable interest rates.

When the inflation rate rises above acceptable levels, the FOMC can raise its federal funds interest rate, which causes lenders to raise their prime rates. As a result, consumers are less likely to borrow money. “As the cost of debt increases for borrowers, this is slowing down the economy,” says Tuyo, which could help curb rising inflation.

If, on the other hand, the inflation rate falls to a level that indicates economic stagnation or contraction, the FOMC may lower its interest rates, which ultimately encourages more borrowing, which will help increase consumption and economic growth.

Mortgage rates

FOMC does not set mortgage rates, and although its federal fund rate may affect the floating rate of an adjustable rate mortgage through the short-term interest rate index used by your lender, it does not affect fixed mortgage rates.

That said, fixed mortgage rates are affected by the 10-year government bond, which is a government bond issued by the US Treasury Department with a maturity of 10 years. Because it is backed by the federal government, investors consider the 10-year treasury a risk-free investment.

“When inflation expectations are high, bond buyers will bid less on long-term bonds,” says Dieterich, “which raises bond yields as well as the mortgages that use them as a basis for pricing.”

What this means for you

The effect of inflation on interest rates can vary depending on your current loan types and your loan plans. Here’s what you can expect with different types of credit:

  • Credit card. The vast majority of credit card has a variable interest rate, which means that the interest rate fluctuates over time based on the prime interest rate. You can generally expect your interest rate to change within one or two months of a change in the federal funds rate, and this is usually in line with the interest rate change. For example, if FOMC increases its interest rate by 0.25, expect that increase in your credit card’s annual percentage rate.
  • Personal loans. Generally, personal loans have fixed interest rates, which do not change during the term of the loan. If you currently have a personal loan, inflation will not change your interest rate. However, personal loan companies are likely to raise their interest rates for new borrowers within one or two months of an interest rate hike by federal funds, so if you plan to take out a personal loan soon, you may be able to pay more interest.
  • Credit lines. If you have a personal credit or a home equity credit, your interest rate will usually be variable. This means that your interest rate can increase within a few weeks after an interest rate increase. In some cases, credit lines may allow you to convert some or all of your existing balance to a fixed interest rate. If so, you can save money by locking in a fixed interest rate now, as FOMC is expected to increase its interest rate several times in 2022.
  • The car. Just like with personal loans, car loans usually have a fixed interest rate, so you do not have to worry about your borrowing costs increasing on an existing loan. However, increases in the federal funds rate may cause auto loan rates to rise for new borrowers.
  • Student loans. If you have federal student loans, your interest rates are fixed throughout the loan period, so you do not have to worry about inflation affecting your interest rate. In all cases, private student loans at school and refinance student loans may come with a fixed or variable interest rate. An increase in the federal funds interest rate will result in an increase in your variable interest rate on an existing loan, as well as on both fixed and variable interest rates on new loans.
  • Mortgage rates. If you have one fixed mortgage rate or if you are in the fixed period of a mortgage with an adjustable interest rate, which can be anywhere from one to 10 years, inflation will not affect your current interest rate. However, if you have passed the fixed period on a mortgage with an adjustable interest rate, your interest rate usually changes every six or 12 months based on the short-term index used by your lender, such as the interest rate for a secure overnight stay. Prospective home buyers can also expect higher interest rates on new mortgages.

What you can do to counter rising interest rates

If you are worried about how rising inflation and interest rates will affect your budget, there are some steps you can take to limit their impact on you:

  • Pay off credit card debt. If you have a credit card balance, make it a priority pay off as quickly as possible. Tuyo recommends that you use a private loan to consolidate your debt and convert it into a fixed-rate loan. Then prioritize paying your credit card balance on time and in full each month in the future to avoid interest costs.
  • Borrow only when needed. Rising interest rates can deter loans due to the higher cost associated with the loan, and this is not always a bad thing. If you have considered taking out a personal loan or using a credit card to buy something you do not need, it may be a good idea to reconsider.
  • Refinance your mortgage with adjustable interest rates. Fixed mortgage rates are already on the rise, but if you stick to your mortgage with adjustable interest rates, you can end up paying much more. Take the time to research your options to determine if refinancing is right for you.
  • Improve your credit. If you are planning to borrow soon, consider taking your time improve your credit rating before applying. While interest rates generally increase, a high credit score can help you secure a lower interest rate and maximize your savings.

The important thing is to be aware of how your borrowing and spending habits affect your financial well-being and to adapt your habits based on financial conditions.

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