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October 2, 2020

How do macro interest rates affect your personal finances?

Even the most determined hermit would find it difficult to escape some mention of slowing GDPs, recessions, collapsing economies, and trade wars in 2020. Sure, there is a sense of rising hysteria and loud conversations about the state of the economy, but how does it really flow down to the individual investor? Some metrics hit harder than others: we all probably know someone who lost their job or had to take a paycut in order to stay employed, or went through the ordeal ourselves. Other metrics seem completely removed from our current reality, like the tech boom and inexplicable stock market rise. So where do interest rates fit into the whole economic environment and our lives?

Debt has somehow become a staple of life in the US in the last few decades. Because of that, interest rates have a bigger effect on our personal finances than we realize. For example, do you know the interest rate on the following:

Is all dependent on the interest rate that the Fed sets? Let’s dive in to some aspects of interest rates and personal finances:

Your spending

Changes in interest rates can sneakily impact your spending habits depending on factors like current rate levels, expected future rate changes, consumer confidence, and the overall health of the economy.

For example, have you ever considered speeding up a major purchase because the provider was offering 0% introductory rates? Interest rates can serve as an incentive or a deterrent to spending. If interest rates are low, people may get a $500 bonus or gift and decide it’s not worth earning $0 in a savings account. They might spend it on something they need, or even decide to borrow more money with a low interest rate loan or credit card to purchase something for $1,500.

Your saving

On the flip side, interest rates also impact our marginal propensity to save. An increase in interest rates at the macro level will encourage banks to offer higher rates on their savings accounts as well. This makes savings seem more attractive to average individuals. So if you’re looking to increase your savings rate, you’d want the Fed to increase interest rates.

This is why average investors are often interested in locking in high interest CDs (certificates of deposits) while rates are high, so that they are protected from the risk of lowering interest rates for the next 2-3 years.

The charts below show the US household savings rate and the bank prime loan rate from 1960 – 2020.

US households savings rate as a % of income

The prime loan rate

While there isn’t a direct correlation—the savings rate this year reached a high of 33% despite historically low rates due to the pandemic—there is a relationship between the two variables that can be seen over time.

Your borrowing

While savers get the benefit of delaying their spending in the form of interest, borrowers must pay interest in order to access funds in the present. The average balance on a credit card is now almost $6,200, and the typical American holds four credit cards, according to the credit bureau Experian. Credit cards have variable interest rates that are ultimately tied to the prime rate, but consumers have to pay much higher interest rates in order to use the credit cards. In fact, as of September 2019, the average credit card APR was 15.99 percent, according to Bankrate data.

In some cases, student loan rates are also closely related to Fed interest rates. If you have variable interest rate loans, your rates will likely go up with a Fed rate increase and decrease with a Fed rate cut. If your student loan interest rates are fixed, your rates are set from the very beginning of the loan, regardless of what the Fed does. You can, however, refinance loans and opt for a variable rate in a decreasing interest rate environment.

Your mortgage

Before the great recession in 2007, the economy was booming because of an out-of-control housing market. In 2001, the Federal Reserve had lowered its targeted federal funds’ rate from 5.5% to 1.75%. It suddenly became very easy to borrow for mortgages or get lines of credit for home construction. There were record home sales and property values—until it all came crashing down.

The housing boom era may not have been the intended result of the federal reserve’s decision to slash rates dramatically, but almost 20 years later the relationship between federal interest rates and mortgages is still going strong. As the Fed has announced its decision to keep interest rates low for the foreseeable future, mortgage rates have fallen significantly.

If you’re a homeowner, this could be a good time to look into refinancing as we suggested for student loans in an earlier section. A refinancing could allow you to shave off a few percentage points from the interest rate on your mortgage, leading to thousands of dollars saved over the long term.

One way to take advantage of real estate market returns and cash flows without the risk of housing boom and bust cycles is to look into REITs. REITs are somewhat protected from interest rate risk, and can be a great way to introduce diversification into a financial portfolio.

The takeaway

The Federal Reserve rate is just one of many economic variables that shape (and indicate) expectations toward consumption, saving, borrowing and lending. These indicators are analyzed ad nauseum by macroeconomic experts and the news media, and it’s easy (and tempting) to stay at that 1000-feet level when looking at the data. However, these economic factors can have a real impact on individual investors and average Americans. If you’re unsure about how to make major financial decisions at an uncertain time or are looking for ways to prioritize your saving and spending, looking to external factors like Fed interest rates can give you some much-needed context.

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