Interest rates affect the cost of debt and can have a dramatic effect on many areas of your financial life. From credit cards and auto loans to mortgages and more, understanding how interest rates work can make or break affordability for your debt obligations.
As rates increase, buyers’ borrowing power diminishes and they may need to opt for lower-priced homes in order to maintain their payments. Conversely, when rates decline homeowners can save money and pay down debt faster.
1. Higher Interest Rates Mean Higher Monthly Payments
Interest rates play a large role in financing costs associated with everything from cars and homes to credit card balances. When key borrowing rate benchmarks such as the federal funds rate increase, so too do your borrowing costs.
Changes in interest rates can make even the best-laid financial plans unworkable. When purchasing a car or home, loan payments should be estimated beforehand to ensure it fits within your budget. Should interest rates spike before locking in the loan agreement, that $500 monthly payment could quickly turn into $650!
However, higher interest rates do have their benefits. Banks will typically increase savings account yields to attract depositors; inflation-indexed bond yields and entitlement payments like Social Security tend to rise when interest rates increase.
2. High Interest Rates Increase the Total Cost of Borrowing
Interest is the amount lenders charge borrowers on loans they provide them, to cover the risk that the borrower may not pay back the loan as promised and to encourage instant purchases rather than waiting to save up.
As rates rise, borrowing becomes more costly – leading to higher monthly payments for new debt as well as increasing annual percentage rates (APR) on existing adjustable-rate loans such as credit cards and mortgages.
Lenders may become increasingly selective in who they lend to, fearing borrowers can’t afford their payments or have poor repayment histories. A recent Bankrate poll discovered that lending to people with lower credit scores has declined faster since the Federal Reserve started raising rates – particularly among people of color, who tend to have lower scores and may lack resources like down payments and cash reserves to protect themselves against high rates.
3. Higher Interest Rates Increase the Total Cost of Debt
Interest rates that rise make borrowing money more costly, which shows up on monthly bills and hinders your ability to take out new loans or pay back existing ones. This can impact both new loan applications and existing ones that you owe back.
Credit card debt tends to come with short-term interest rates, while mortgage and student loan debt usually have long-term rates like those found in 10-year Treasury bonds. No matter what form of debt you hold, interest rates have an effect on how easily and quickly money can be borrowed in order to meet financial goals that require borrowing money.
As interest rates increase, homebuyers must adapt their budgets or focus on lower-priced properties to maintain affordability of homeownership. Unfortunately, mortgage originations is decreasing causing supply shortages for prospective buyers; thankfully there are programs offering rate buydowns for eligible borrowers which help individuals afford mortgage loans despite lower income levels; also, increasing percentage of eligible borrowers could help foster increased homeownership rates.
4. Higher Interest Rates Increase the Total Cost of Owning a Home
Mortgage interest rates not only directly influence monthly payments, but total housing costs also rise when rates go up. When this occurs, buyers pay more overall and may even be priced out of houses they could otherwise afford if interest rates had been more manageable.
Rising interest rates can reduce demand for homes, particularly among first-time homebuyers. Those still able to purchase might experience more competition for available listings and homes may remain on the market longer as existing homeowners opt to keep their low rate mortgages rather than sell at this stage of their mortgage cycle.
Many homeowners believe the best course of action is waiting until interest rates decline, not only making qualifying easier but potentially saving thousands over time. When interest rates are lower, it is always worth comparing costs of renting against buying; differences can often be substantial.
