The Federal Reserve raised interest rates in March to their highest level in a decade, and more increases are on the way.
Higher interest rates will affect consumers in many ways — including car and home loans, though most borrowers who have those loans are at set rates that don’t change for years, if at all. Where most consumers will see a change is on their credit cards, where interest rates can change daily.
For a U.S. household with the average credit card debt of $10,995, a 0.25 percent hike in interest rates — which is how much the Fed raised its key interest rate on March 21 — could make carrying a credit card balance more costly.
How the Fed raises interest rates
The Fed raised its benchmark rate from 1.5 percent to 1.75 percent, the highest level since 2008. It raised rates three times in 2017 and has signaled that it anticipates raising rates three times in total in 2018, possibly four times.
The benchmark rate has risen a full percentage point in the past year, and further hikes this year will make credit cards at least twice as expensive to carry a balance on than they have been for about a decade.
Technically called the federal funds rate, the interest rate the Fed sets is the rate banks trade federal funds with each other overnight. It is almost exactly correlated with the prime rate, which is what credit card companies typically charge their largest, most creditworthy corporate clients.
From there, a change in the prime rate follows with credit card interest rate changes that consumers see. Their credit card interest rate will usually increase with a day of the federal funds rate increase, and usually at the same amount. So a 0.25 percent increase in the federal funds rate equates to a 0.25 percent increase in a credit card interest rate.
After holding steady at an average interest rate of 13.5 percent in 2016, and around that rate or lower since 2013, the average interest rate on credit card accounts that assess interest has risen almost two percentage points in less than two years, according to data from the Federal Reserve. In 2017 it averaged 14.44 percent, and as of February 2018 it was 15.32 percent.
If the Fed raises rates 1 point by the end of the year, credit card users could see their average interest rate at about 16.3 percent.
Credit card pain
Carrying a credit card balance, also known as revolving credit, is where credit card users will feel the pain of a Fed interest rate hike. An estimated 40 percent of credit card users carry a balance from month to month, and should see their costs climb immediately after a Fed rate hike.
Most credit cards have variable interest rates. As banks see their borrowing costs rise, they raise rates on credit cards.
If the Fed increases interest rates during the middle of a credit card billing cycle, for instance, customers may not see the increase until their next statement is due. But their rate may rise on new purchases immediately.
Lenders are typically more likely to raise interest rates faster than they would lower them if rates were dropping elsewhere.
As we said earlier, any rate hike by the Fed should be almost immediately mirrored in a credit card rate hike. With that, the minimum due on a credit card balance will rise.
Credit card minimum payments are typically set at 1-2 percent of the principal balance, plus any interest accrued during the billing period. Rising interest rates will increase the accrued interest and minimum due, though not dramatically.
For example, with a credit card debt of about $8,600 at an interest rate of 15 percent, the minim due is $101 when a 1 percent rate of the principal balance plus accrued interest is factored. Add a rate increase of 0.25 percent and the minimum due goes up to $102.
A 0.25 percent increase in interest rates causes the minimum due on a credit card to jump by $2 for every $10,000 of credit card debt.
That’s not a lot of money, but two or three more Fed rate jumps this year and it can add up. Credit card interest rates are already about 2 points higher than they were two years ago, so adding another point means a $24 increase on the same debt from 2016 — each month.
What to do
The best thing credit card users can do to avoid the pain of rate hikes is an obvious and sometimes difficult one — don’t carry a balance. Pay off your credit card each month and pay it on time to avoid fees.
If you have a good credit score, you can apply for a credit card with a lower rate and transfer your balance to the new card. At the very least, work to improve your credit score so that you qualify for the best rates.
You can also try to get a personal loan at a low interest rate to pay off a higher credit card balance. Getting your spending under control can help ensure you don’t go into more debt.
The post How Federal Reserve Interest Rates Affect Your Credit appeared first on Better Credit Blog | Credit Help For Bad Credit.
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