Interest rates affect our ability to borrow money from banks and financial institutions. Typically, interest rate movements receive scant attention around the dinner table, since many of us do not understand the impact of interest rate fluctuations over the long-term. However, a 25-basis point rate hike from 1.00% – 1.25% to 1.25% – 1.50% is significant. These fractional movements must be considered over the lifetime of a long-term loan which is typically 30 years. When you’re paying interest on your interest, every 25-basis point movement is substantial.
The Federal Reserve Bank expects to increase the federal funds rate towards 2% by 2018, and 3% in 2019. This has far reaching implications for homeowners, and intending homeowners. It is also a major consideration with things like credit card repayments, personal loans and business loans. Many of us are blithely unaware of the impact of a 0.25% hike in the interest rate. From an economics perspective, the impact of a rate hike is as follows:
- When the Fed FOMC (Federal Open Market Committee) approves a rate hike, the cost of borrowed money increases for investors. This means that more interest has to be repaid on borrowed funds. It has a contractionary effect on bank borrowing, and it also results in increased savings since more money stands to be made with fixed-interest-bearing accounts.
- The USD typically appreciates slightly in the run-up to the rate hike since more interest stands to be made on dollar-denominated investments.
- Stock markets react in a mixed fashion to rate hikes. On the one hand, a rate hike indicates an improving economy, and this results in more investment in stock markets. On the other hand, a rate hike means that listed companies will have to pay more on their borrowed capital (higher interest rates), so this reduces profitability. Companies then pass these costs onto consumers in the form of higher prices which may have a contractionary effect on investment.
How Do Rising Interest Rates Affect Current Homeowners?
From a personal perspective, rising interest rates mean that you will be paying more for mortgage loans. However, if you already own your own home, rising interest rates can only affect you if you have a variable mortgage rate. This means that your interest repayments move in tandem with the prevailing interest rates in the country. Many folks prefer fixed interest mortgages, knowing that they can only go up from their historic lows.
Fortunately, anyone who is locked in a low interest rate since 2008/9 will be smiling all the way to the bank. For people with mortgages in place before rates dropped to historic lows, there is some hope on the horizon. According to a mortgages refinancing Q&A by CreditLoan.com, mortgage refinancing can save tens of thousands of dollars over the long-term, especially when interest rates are significantly lower than your prevailing mortgage interest rate.
While many folks consider cost savings on credit cards (cashback, rewards, limited-time offers) to be a boon, there are much bigger cost savings with mortgage refinancing. When you refinance your mortgage, you end up paying significantly less over time. There are certain yardsticks that need to be considered before you can evaluate your personal financial situation. For example, your mortgage payment should never be greater than one third of your income level.
If your repayments are too high, you are known as house poor. If all of your money goes into your property, you become a slave to that property and no utility is generated from it. By refinancing your mortgage and paying significantly less over the lifetime of your loan, you can avoid that wastage and live a better-quality life. This can manifest in several ways such as renovating/remodelling your home, putting money away for savings, planning vacations etc.
Making the Switch from an Adjustable Rate Mortgage to a Fixed Rate Mortgage
According to the National Bureau of Economic Research, the average US homeowner could have saved at least $45,000 over the lifetime of their loan by refinancing when interest rates were at rock-bottom prices. Refinancing is available through banks, financial institutions and non-bank entities. It’s important to be preapproved by top lenders beforehand, and then to evaluate as many different refinancing options as possible.
When you pay off your current mortgage with a loan with a significantly lower interest rate, you’re already saving money over the lifetime of your loan. If you switch from a 30-year loan to a 15-year loan, you will save a ton of money over the lifetime of your loan, but you will pay more in monthly fees. These are points to consider when refinancing your mortgage, or switching from an adjustable rate mortgage to fixed-rate mortgages.