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How Will An Interest Rate Change Your Accounts?

Posted at 1:03 PM, Dec 19, 2015
and last updated 2015-12-19 16:03:49-05

Unless you pay no attention to financial news at all (and if not, how did you end up here?), you are aware that the Federal Reserve has finally raised interest rates after seven long years of near-zero rates in an attempt to stimulate the economy. The common prediction was for a 0.25% rate increase, and the Fed followed through as expected.

How will the Fed's actions affect your savings account and/or your mortgage? Based on the Fed's outline of a very measured rise in rates, there probably will be very little effect.

In a theoretical rate hike cycle, banks will increase their mortgage rates to accommodate the change in the Fed's benchmark interest rate and will then have more revenue to pass along to savers as higher returns on their deposits and other cash-based investments such as CDs. In reality, banks will react to demand as much as an interest rate, and the demand can be affected by the psychology of an interest rate hike.

In mid-2004, the Fed's benchmark rate was 1% and a series of 0.25% or greater interest rate hikes began. During the first increment, 30-year fixed rate mortgages actually dropped from nearly 6.3% to 5.7%. After two years of increases, the 30-year fixed rate climbed to 5.25% but the 30-year fixed rate only rose from a low of 5.58% up to 6.68%. Banks do not always set rates in lockstep with the Fed's benchmark. There is actually a better correlation between mortgage rates and 10-year Treasury bonds than there is between the mortgage rate and the benchmark rate.

Consider the dynamics at the moment. Banks are sitting on large volumes of cash and are being hamstrung within the mortgage market by regulatory reforms, while the housing market is improving but still suffers from a mismatch between qualified homebuyers and available homes. A small increase in the benchmark rate is not likely to increase demand by scaring more people into buying when they would not normally have done so — unless the Fed strongly implies that rates will rise at a faster pace than they have let on so far.

Should that happen, there could be a tangible increase in demand and sales as people "settle" for a less desirable home to take advantage of rates. That demand should allow banks to charge higher mortgage rates — but do not count on that happening this time. As of this writing, the announced increases were a straight pass-through of the extra 0.25%, including statements from Wells Fargo and US Bancorp.

Of course, if you have a variable mortgage or any financial product directly tied to the interest rate, you will see the unfiltered effect of that interest rate on your payments.

What about the effect on savers? It's hard to see how it can get any worse, as average CD rates are stuck at 0.3% — just a bit better than sticking your money under your mattress. However, since banks are flush with cash and have plenty to lend, they have little motivation to offer attractive deals to bring in more cash through deposits. The Great Recession led people to maintain a lower level of risk, including greater cash reserves.

In short, you may be able to find a slightly better deal on your money, but it may not be enough to bother with the hassle of moving it to a different bank. As of this writing, there is no major bank announcing interest increases to help savers.

It has been so long since the benchmark rate has increased that people could overreact, but it seems likely that such a small and telegraphed move will have limited impact. It all depends on the Fed's announcement and how they portray this increase and future ones, and whether it meets people's expectations. So far, it seems to meet with approval.

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