This week the Federal Reserve will meet and could make a simple move with wide reaching implications, a quarter of a percent increase interest rate.
One of the Federal Reserve’s most publicized roles is controlling the supply of money in the economy. Influencing the federal funds interest rate is one of the heaviest hammers it holds in its tool box. The federal funds target rate is set by the Federal Reserve Board and guides the rate that banks use to lend to each other each night when they close their books. More importantly to the general public it can lead to an increase in rates for savers (like money markets and CDS) and rates for borrowers (like car loans, credit cards, and mortgages.)
Why is this meeting more important than others?
The Federal Reserve’s Board has indicated they may raise interest rates from their historically low range of 0% - 0.25%. Whether or not we see a lift-off from this week’s meeting, we are setting a course for a change in policy.
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For eight years the federal funds target rate has been falling. It bottomed at near zero in December of 2008, where it has remained. Since then the economy has continued to recover, albeit slowly1. The stock market has bounced back and unemployment numbers have declined. This has given the Fed the opportunity to consider raising the interest rate and tightening its policy on the rate money flows into the economy.
A hike is an indicator of a shift in policy from accommodative (incentivizing borrowing) to tightened (incentivizing saving). But a slight move up from the Fed will still leave us a very low interest rate environment.
Expect a lot of news and predictions of what will happen next. Google “interest rate hike” today or look for “FOMC” trending on Twitter. There will certainly be a market reaction when the Fed does raise interest rates because that is what markets do--they react to news. Rather than predict how changes in interest rate policy will affect the market, we’ll focus on how it could impact an individual’s financial plan.
The low interest rate policy over the past six years has led to subsequent low interest rates available for individuals to purchase a home. If you buy a home and take out a $300,000, conventional, 30-year-fixed mortgage at 3.75%, you will pay $1,389 in principal and interest payment. Compare this to the nearly $1,610 payment for the same loan at a 5% interest rate. That’s $221 each month that you could have in your pocket, rather than in the bank’s coffers.
A lower mortgage rate will also help you pay down the principal of your loan faster. Using the previous example, you will owe $5,000 less on your loan after just five years.
So if owning a home is one of your goals, work hard to save for your down payment and lock in a low interest rate and you’ll be able to save the extra money that higher interest rates would cost you. If you already own a home and haven’t refinanced yet, it’s time to get to it as you may not see an interest rate this low for quite some time.
People who are good savers know the pain of a low interest rate environment. They have facilitated the borrowing at these low interest rates and in return have been paid back with substantially low interest rates. If you look around for a savings account or money market paying more than 1% annually, you’ll discover that they’re difficult to find. As interest rates rise, the incentive (the amount of money a bank will pay you to keep your money there) to save will increase. This is great news for people headed to retirement soon who rely more heavily on fixed income investments.
So, whatever the action of the Federal Reserve Board this week, the low interest rate environment may be coming to a close. Its impact will be felt by markets and individuals alike.
Patrick Amey, CFP ® is a financial planner at KHC Wealth Management where he works with clients to clarify their goals, create plans and take action.
1. Data from the historical database Board of Governors of the Federal Reserve System. www.federalresreve.gov/releass/h15
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