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By Lois Sullivan
In an attempt to curb rising inflation, the Federal Reserve has taken meaningful and far-reaching steps, including raising interest rates. These rate increases have significantly affected borrowers, including those who want to take out mortgage loans to purchase homes. But beyond mortgages, the rate hikes can also have an effect on other borrowing efforts. Read on to learn more about Fed rate increases and credit cards and if there’s a relationship between the two.
Raising national interest rates is a process called a Fed rate hike or Fed rate increase. It refers to the federal funds rate, which is the interest rate charged by financial institutions when lending to or borrowing from one another. The Federal Reserve sets that rate and adjusts it based on economic conditions. The decision to increase the federal funds rate was made in response to increasing inflation, or the rate of increase on the price of services and goods.
Between mid-2021 and mid-2022, the inflation rate reached 9.1%, marking the highest increase in more than 40 years. The long-term target inflation rate is 1-2%. Housing, fuel and food prices have all been affected, causing American households to feel financially strained and stretched. By raising the Fed rate, Federal Reserve officials attempt to lessen spending, resulting in a drop in demand. However, other factors have impacted the current inflation rate, so it's difficult to determine how effective this measure will be in slowing rising costs.
The interest rate on a credit card is the price the account holder pays for borrowing money from the credit card company. The interest rate is typically expressed as an annual percentage rate (APR), but the rate can fluctuate based on specific benchmarks. You might hear companies refer to the prime rate, which is the rate tied to the federal funds rate. Credit card companies can charge an additional percentage on top of the prime rate, and many do. Investopedia reports that the average credit card APR was 21.99% as of November 2022.
Credit cards differ from loans, as the monthly payment due depends on how much you spent on the card. In contrast, the monthly payment on a loan is usually a fixed amount that's based on the total borrowed, plus interest, split into equal payments. The borrower always pays interest within their monthly payment unless the loan qualifies for 0% interest. But a credit card payment may not include interest if it's paid on time. Cardholders only have to pay interest if they fail to pay off the balance in full by the due date.
Although credit card interest rates are expressed annually, the interest can compound daily. If you don't pay off the monthly balance, that amount will roll over to the next month, along with the applicable interest. But the remaining balance will continue to accrue interest on a daily basis, which explains why credit card debt can quickly get out of control.
As mentioned, the prime rate on credit cards can fluctuate based on the federal funds rate. If the Fed rate goes up, your credit card interest rate will likely follow suit. But the additional interest charged on top of the prime rate usually remains fixed. You can review your interest rate in the pamphlet provided by the credit card company when it issued you the card. This information may also be available in your online account.
Although prime rate fluctuations do follow the Fed rate changes, it's important to understand that every bank and credit card company can set its own prime rate. When the federal funds rate goes up, financial institutions increase their rates accordingly. But the term also reflects who qualifies for this rate: prime or top-tier customers. These are borrowers who financial institutions believe are least likely to default, so they qualify for better rates. Applicants with lower credit scores often get charged higher interest rates.
Dealing with rising interest rates can be overwhelming, especially if you're already feeling stretched due to a rising cost of living. These tips can help you combat the financial woes of higher rates:
If you carry a balance on your credit card — in other words, you're not able to pay off your balance in full each month— pay what you can to get the balance down. Even a seemingly small rate hike can make a big difference if you have a sizable balance accruing interest daily. You might also consider using a balance transfer credit card to qualify for a lower introductory interest rate. Some cards even offer 0% interest rates for a set period. This action can help you manage your debt instead of watching it balloon out of control.
People often get into credit card debt when they live beyond their means, spending more than they earn. When you swipe or insert a credit card, the money doesn't get debited from your account immediately, so it doesn't have the same financial effect as paying with a debit card or using cash taken from your bank account. But when the bill comes due, it's important that you have enough money available to pay it off in full to avoid getting charged interest. Using a credit card can benefit you in many ways, as long as you use it responsibly.
The best way to live within your means is to create a budget and stick to it. Allot money to the essentials first, such as housing, food and utilities, and then figure out what you can afford to spend in the other categories. If you don't have the money to pay for something, try to go without or make a sacrifice in another area. Budgeting can also help you set aside money in a savings account to prepare for the future.
Some credit card companies offer lower rates to well-qualified customers, such as those who have been customers for many years or who have excellent credit scores. If you notice a significant increase in your interest rate, it's worth contacting the company to find out whether you can qualify for a lower one. It never hurts to ask, and if you can prove you're a trusted customer who has continuously paid their bills on time, they just might say yes.
While changes to the federal funds rate certainly have an impact on credit card interest rates, it's helpful to understand that a rising interest rate is only concerning if you don't pay your bill in full each month. If you're in this boat, you can take steps to reduce your credit card debt and improve your financial situation. Before signing up for a credit card, make sure to check the interest rate so you're not surprised when you receive the first bill.
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