The Staggering Cost of a Quarter-Point Interest-Rate Hike

By Sean Williams Markets Fool.com

In case you missed it, the Federal Reserve did something it's only done three times over the past decade on Wednesday -- it increased its federal funds target rate.

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In a widely anticipated move by Wall Street economists, all but one of the Fed governors voted in favor of a 25-basis-point increase in the federal funds target rate to 0.75% to 1%. It's worth noting that while the Federal Reserve doesn't control interest rates directly, its policies have an almost immediate impact on other interest-sensitive assets, such as credit card APRs and mortgage rates.

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The Federal Open Market Committee (FOMC) had all the reasons it needed to lift its federal funds target rate, according to Fed Chair Janet Yellen: an expanding labor market, the firming of business fixed investments, and an upward move in inflation in recent quarters toward its long-term goal of 2%, excluding food and energy. The FOMC stood by its long-term goal of moving the federal funds target rate to 3% in the years to come.

The purpose of the Fed's move is to ensure that the U.S. economy doesn't overheat. Leaving its federal funds target rate low for too long could lead to bouts of high inflation, which has historically proved to be bad for the U.S. economy and investors.

Higher rates are a boon for some

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Some industries and groups of people are clearly going to be excited about the Fed's decision to increase its fed funds target rate. Probably standing at the front of the pack with the champagne are banks and credit unions. A 25-basis-point increase allows banks to pass along higher fees on variable loans and credit cards. Meanwhile, they pass along yield increases on a much slower basis when it comes to interest earned on savings account. In short, it means banks should see their net interest margins increase.

For example, Bank of America's (NYSE: BAC) 10-Q filing with the Securities and Exchange Commission following its third-quarter report signaled that it could earn $5.3 billion more in net interest income if long-term and short-term interest rates rose by 100 basis points. Since that estimate, we've seen two 25-basis-point increases from the Fed. When factoring in Bank of America's shrinking costs via branch closures, each quarter-point hike in interest rates could mean $0.10 or more in annual EPS gets added to B of A's bottom line.

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Payroll processors are another group that'll be thrilled with the rate hike. A giant in the field like Paychex (NASDAQ: PAYX), which has already been benefiting from steady employment growth, gets a separate benefit in terms of higher short-term yields. Paychex earns investment income on its float essentially the money it receives from companies that's paid out to employees. This money isn't paid out the day it's received, giving Paychex time to earn interest on this large pool of cash. Higher interest rates mean more investment income for Paychex and payroll service providers.

Even seniors should be doing the happy dance in light of the Fed's move. While it's unlikely to do much for savings accounts, it could provide a nice yield boost to CDs and bonds. Additionally, since the Social Security Trust's more than $2.8 trillion in spare cash is almost entirely invested in special-issue bonds from the U.S. government, a higher rate environment could begin yielding more in interest income for the trust.

The staggering cost of the Fed's rate hike

However, the Fed's rate hike also comes with some staggering costs for millions of Americans, and the U.S. government.

According to WalletHub, the 25-basis-point increase in the federal funds rate is expected to lead to $1.6 billion in added finance charges this year for the 157 million Americans who carry a balance on their credit cards. The analysis further broke this figure down to an extra $14 per quarter for each household. That may not sound like a lot ($56 more per household, annually), but we're still early on in the rate-hike cycle. By year's end, we could be looking at a $42 increase per quarter, or $168 for the year, per household, if the Fed holds to Wall Street's consensus and hikes rates three times. That's no longer chump change.

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Most mortgages tend to be of the fixed-rate variety, so a Fed rate hike is of no consequence. But prospective homebuyers, and those with variable rates, could feel the pain. For example, the average 30-year fixed-rate mortgage has risen by 88 basis points since hitting a record low of 3.50% in December 2012. This extra 88 basis points over 30 years on a home loan of $200,000 means you're paying an extra $36,400 over the life of the loan in interest, assuming no early repayment.

But the real jaw-dropper comes from the federal government, which is nearly $20 trillion in debt. According to estimates from the Congressional Budget Office, each 1-percentage-point increase in interest rates is expected to add $1.6 trillion to the 10-year budget deficit. It's worth pointing out that most of these costs are back-loaded, with $262 billion of these costs coming out in the 10th year as costs and borrowing accelerate. The CBO figures that borrowing will increase to $30 trillion from $20 trillion a decade from now.

Breaking this down further, Wednesday's rate hike equates to about a $400 billion increase in the 10-year federal budget deficit. With three rate hikes anticipated in 2017, we're talking about an estimated $1.2 trillion being added to the federal budget deficit over the next decade. These quarter-point hikes, while necessary to control inflation, can prove devastating to a federal balance sheet that's already drowning in debt.

We may tend to overlook a 0.25% hike in interest rates as trivial, but these added costs suggest it's far from inconsequential.

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Sean Williams owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.