Why the Federal Reserve raised interest rates — and how it will affect your money

ByJames Dennin

Your credit cards, home loans and, yes, student loans are about to get more expensive: The U.S. central bank, the Federal Reserve, announced Wednesday that it would proceed with its planned rate hike, bringing the prime short-term interest rate — a benchmark percentage that affects how much lenders like credit card companies or loan brokers charge borrowers, in turn — up to a range of 1% to 1.25%, from the previous range of 0.75% to 1%.

This highly anticipated announcement has been the subject of great debate in recent months, for several big reasons. For one, the Fed, led by Board of Governors Chair Janet Yellen, is keen for rates to return to more historically normal levels. Ever since the recession, the Fed has kept short-term borrowing costs near zero and also kept long-term rates low by keeping a huge portfolio of government bonds on its balance sheet.

The desire to return to "business as usual" appears to have outweighed any concerns, said J.W. Mason, an economist at the left-leaning Roosevelt Institute.

"The Fed is not comfortable with this persistent zero, or very low rates," Mason said. "They want to be back in the world of what they see as normal policy, they want things to look like they did in 2007 whether it’s what the economy needs or not."

Indeed, policymakers worry that if the Fed doesn't soon start unloading bonds and thus raising long-term interest rates, it won't have leverage to stimulate the economy when there's another slump. As recently as Tuesday, the Fed was expected to begin selling about $10 billion in bonds each month, in a "normalization" process the New York Times reports could take 30 years.

Regarding the bond sale, the new Fed statement said it plans to begin its "balance sheet normalization program this year, provided that the economy evolves broadly as anticipated."

So why, exactly, were people hoping the Fed would not raise rates? Essentially neither inflation nor the economy has really been cooperating by providing evidence it is strong enough to absorb the rate hikes. Shortly before the Fed's announcement on Wednesday morning, it was reported U.S. consumer prices fell 0.1% in May — as opposed to the 0.2% gain policymakers expected. That has cast doubt on the Fed's prediction from its May meeting that "slowing in growth" during the first part of the year is "likely to be transitory."

As New York Times correspondent Binyamin Appelbaum tweeted, the Fed's optimism that inflation will return to healthy levels has persisted despite evidence to the contrary.

So what are the main justifications for the new rate hike? "Job gains have moderated but have been solid, on average, since the beginning of the year, and the unemployment rate has declined," the Fed statement reads. "Household spending has picked up in recent months, and business fixed investment has continued to expand."

You might be wondering what this all means for you. When the federal funds rate goes up, it technically only affects the short-term rates at which banks can borrow money — but the banks tend to pass these higher costs on to consumers.

Greg McBride, chief analyst at BankRate said customers can expect to see rates begin to climb on their credit cards, for example, within the next 60 days. The longer the Fed keeps rates where they are, the longer consumers can expect to benefit from cheap lines of credit.

"Your credit card rate will be 1 percentage point higher than it was two years ago, and the minimum payment on your $30,000 home equity line will now be $25 more per month than it was before the Fed started hiking rates," McBride said in an email. "The combination of rising debt burdens and rising interest rates is straining some households, with delinquencies picking up from recent lows."

The nuance is, higher rates aren't necessarily all bad for consumers, especially savers. Typically, when banks earn more interest on their deposits, some of the extra earnings get passed on in the form of better-paying savings accounts and other short-term savings vehicles, such as certificates of deposit, although that hasn't been the case with the latest round of hikes: Twelve-month CDs with a $10,000 minimum balance paid only about 0.25% in May, according to RateWatch. That's down from about 4% during the recession.

Still, smart savers can benefit from shopping around in this rising-rate environment. Here, for example, are several bank accounts that pay above-average interest — up to 5% on your cash.

The concern now is whether people can afford to have their debt get any more expensive than it already is, particularly if they have loans with a variable interest rate: "Yellen is keenly aware of the risk," McBride said. "The last two rate-hike cycles have not ended well."

In general, the Fed has to strike a tricky balance between keeping the economy growing — and businesses hiring — through lower borrowing costs, while raising those rates to prevent prices from rising too quickly, once business activity is humming along on its own. Thus the Fed raises and lowers the cost of borrowing, which also then affects consumers, workers and employers.

Many of the Fed's projections to now may have been too "optimistic," as Business Insider's Pedro Nicolaci da Costa put it. Inflation — when costs start rising in response to a growing economy — has been below the Fed's targets for much of the recovery.

When the Fed raised rates last December by just 25 basis points — aka from a 0.25%-0.5% range to a 0.5%-0.75% range — as many as 8.6 million consumers experienced "financial challenges" within the first three months, according to TransUnion. That's despite the fact that average borrowers only saw their interest payments increase by about $18 a month, which seems a manageable adjustment.

Thomas Niedermueller/Getty Images

The problem is, if you're living paycheck to paycheck, even an $18 swing can put you underwater, McBride said, one possible explanation for why even people with "super-prime" credit scores have struggled. That's particularly notable, because "super-prime" borrowers usually have scores of 740 or more, and because they are deemed to be the the least risky, they also pay the lowest possible rates.

"It’s not purely a function of income," McBride said. "There’s plenty of people who, the more they make, the more they spend."

Other economists have expressed concern that the Fed's decision could jeopardize already sluggish wage growth. In a statement before the announcement, the Roosevelt Institute's Mason called the proposed rate hike "irresponsible."

"It’s very unclear how much interest rate changes by the Fed actually affect how easy it is for you or I to get a loan," Mason said. "But what they definitely do is increase the burden of debt for people who already have debt. There are lots of loans that are linked to the overnight rate at the Fed. Those rates, every time the Fed raises rates, it increases the burden of debt on those people."

The rising burden of household debt isn't the only example of mixed signals in the U.S. economy. As Andrew Ross Sorkin noted in the New York Times, though business sentiment — how CEOs say they're feeling about the direction of the economy — is near an all-time high, CEOs aren't following that sentiment with action, with mergers and acquisitions down 40% from the same time last year. When the economy is strong, executives usually take advantage by ramping up deal-making activity.

If you're anxious about rising interest rates, the most important thing to do is to refinance any of your debts that are on a variable interest rate, McBride said, since these are likely to continue climbing more if the economy improves.

Many balance transfer credit cards are also still offering 0% APR as an introductory rate for up to 18 months, he said, which is a pretty wide window to get your debts under control without having to worry about rate hikes increasing your expenses.

If you have multiple credit cards with multiple balances, apps like Tally (available to the public soon) might be able to help you save money by prioritizing all your different payments. If you have a varied interest student loan or mortgage, you might want to refinance with a new lender at a fixed rate that won't continue to climb. Services like Student Loan Hero, BankRate and NerdWallet all compile reputable lenders and can help you compare and contrast different providers.

Need more advice about paying down debt? This smart strategy seems to work best for most people.

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