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What Happens When Interest Rates Rise?

People are always talking about a good vs. bad economy. Now the hot topic is inflation and interest rates. But what happens when interest rates rise and what does it have to do with inflation?

The most basic equation is supply and demand. When demand is high and supply is low, prices tend to rise. So one way the government tries to cut demand is by raising the cost for you to borrow money.

Read on for a quick explainer about what's happening in the economy and what you can do to prepare!

Different Types of Interest Rates

Interest rates can refer to several things and it's important to understand the different terms when you're thinking about what happens when interest rates rise.

Rates on Borrowing

When you get a credit card or take out a personal loan, your lender charges you an interest rate in return for the money you borrow.

  • The annual percentage rate (APR) generally includes the interest rate plus other fees.
  • You want to make sure you compare the APR (not just interest rates) because the APR reflects the true cost of borrowing.
  • Fixed rates stay the same throughout the life of the loan.
  • Variable (or adjustable) rates go up and down with any changes in market interest rates.

Rates on Savings

When you deposit funds into a savings account, certificate of deposit (CD) account, or investment account like an IRA, your financial institution pays you interest in return for using your money while you're leaving it to grow.

This interest rate is known as the annual percentage yield (APY). You may also earn dividends on your savings funds or any stocks you hold.

The Federal Funds Rate

The Federal Reserve sets an interest rate, which is the amount that financial institutions pay to borrow money from each other overnight. Financial institutions, like banks and credit unions, do this to ensure they have the legally required amount of funds in their reserves at all times.

When the Federal Reserve raises the Federal Funds rate, it sets off a chain reaction in the economy. Financial institutions have to pay more to borrow from each other, so they will charge you, the consumer, more to borrow from them. They may also offer a higher APY on your savings.

Why Interest Rates Are Rising

Interest rates are often tied to inflation, which is a measure of how much the prices for consumer goods are rising. Consumer goods include everything from groceries to gas. The U.S. Government is trying to slow inflation by raising the Federal Funds Rate

When interest rates rise, it's thought that consumers will borrow less (through loans and credit cards) and therefore have reduced purchasing power. This leads to falling demand for consumer goods and less demand usually means prices drop.

Currently, many countries around the world are experiencing high inflation because of a combination of factors:

  • Ongoing supply chain issues caused by the global COVID-19 pandemic
  • Fuel and grain shortages caused by the conflict between Russia and Ukraine

How to Prepare When Interest Rates Rise

So what happens when interest rates rise and how does it impact you? When interest rates rise, you need to take a look at all the ways you're borrowing money and find out if you have a fixed interest rate or a variable interest rate.

If you have a fixed rate, then your payments won't change. But if you have a variable rate, you may find yourself paying more in interest. This will likely affect your monthly payment as well as your total cost of borrowing.

Loan Products That Often Have Fixed Rates

You need to check the terms of your particular loan or credit card to make sure, but these products tend to have fixed rates:

  • Personal Loans
  • Auto Loans
  • Home Equity Loans
  • Fixed-Rate Mortgages

Loan Products That Often Have Variable Rates

Again, check the terms of your loan or credit card because some credit cards do offer fixed interest rates. But these products tend to have variable, or adjustable, interest rates:

  • Credit Cards
  • Home Equity Lines of Credit (HELOCs)
  • Adjustable-Rate Mortgages (ARMs)

How to Save on Rising Interest Costs

If you have any variable-rate products (like a HELOC or ARM), you may be able to save money by refinancing and switching to a fixed-rate product (like a home equity loan or fixed-rate mortgage).

If you have multiple credit cards with high balances, you may save money by consolidating your variable-rate credit card debt into a fixed-rate personal loan.

Next Steps: Choosing the Best Way to Make Purchases

Now that you understand how to combat rising borrowing costs, you may want to turn your attention to your spending. Can you avoid paying interest and save money using cash? Or are there significant benefits to using your credit card? Click below to find out!

Cash or Credit Card: Which Should You Use? | Best Reward