Interest Rates Are on the Rise. Here's How to Prepare

MarketsMotley Fool

Back in 2015, interest rates were near zero. We were living in a borrower's paradise.

But times are changing. Since December 2015, the Federal Reserve has increased interest rates six times, most recently from 1.5% to 1.75%. They have plans for three more increases this year, as well as multiple increases in both 2019 and 2020.

Continue Reading Below

In general, this is good news. The Fed stated that the outlook for the U.S. economy has strengthened recently, and it forecast even lower unemployment rates and increased GDP growth over the next couple of years.

However, because the interest rate set by the Fed impacts consumer interest rates, the cost of borrowing will continue to go up. Whether you have debt or are planning to borrow soon, this is not a reason to worry -- but it is a reason to prepare.

How increased interest rates from the Fed affect your debt

Fixed-rate loans are unlikely to change in the near future. The Fed's rate hikes will more directly affect consumers with variable debt.

  • Credit card debt. People with credit card debt will see an instant, though small, increase in their interest rate. Fed increases trigger an immediate increase in the prime rate, which is what credit card issuers use to set their own interest rates. While individual increases are minimal, they do add up over time. According to WalletHub, the interest rate hikes since December 2015 have cost cardholders an extra $6.8 billion in interest so far.
  • Student loan debt. Federal student loans are offered at a fixed rate, so they will remain unaffected. Most private student loans, however, are offered at a variable rate. Interest rates on these loans will continue to increase gradually.
  • Mortgage debt. The Federal Reserve does not directly influence mortgage rates. Fixed-rate mortgages don't follow short-term interest rate hikes, but instead closely follow 10-year U.S. Treasury note yields, so they won't see an increase any time soon. Adjustable-rate mortgages, however, can see an immediate impact, as they are usually tied to short-term interest rates such as the one-year Treasury bill, COFI, or Libor, all of which tend to track the federal funds rate.
  • Auto loan debt. Auto loan interest rates are not directly tied to the federal funds rate, and your credit score is much more important in determining your interest rate when it comes to auto loans. While you might see a minuscule increase, don't expect any significant changes.

What you can do to prepare for rising interest rates

Instead of panicking over a steadily increasing interest rate, take action. Here are some tips on how to prepare yourself financially.

1. Double down on your debt

Make it a top priority to pay off any variable debt, particularly credit card debt, while interest rates are still relatively low. Put any extra money, such as your 2018 tax return, toward your debt. Use the "debt avalanche" method to repay your highest-interest rate debts first before those rates get even higher.

You may also want to consider consolidating your debt at a lower interest rate. If you have a good credit score, you can even open up a credit card with a 0% introductory APR on balance transfers and transfer a chunk of your debt to be paid off interest-free for up to 21 months. Most cards will make you pay a 3% balance transfer fee, but you may still end up saving a significant amount of money. With interest rates on the rise, some of the best balance transfer and 0% APR deals are likely to disappear soon. Citigroup (NYSE: C) CFO John Gerspach stated on a call with investors that the company plans to shorten or remove promotional offers as interest rates continue to rise.

2. Shop around for lower interest rates now

Be proactive and look for lower interest rates. You'll need a good credit score and a history of on-time payments, but this could be as easy as calling up your card issuer and negotiating a lower rate. A survey from CreditCards.com shows that more than 80% of people who called their bank asking for lower fees and interest rates got what they wanted.

You can also shop around with other credit card providers. Keep in mind that actually applying for a credit card will result in a "hard inquiry" on your credit report, which will lower your credit score temporarily, so wait until you're certain. Credit unions are a great option, as they are not-for-profit institutions that pass off profits to members in the form of lower interest rates and fees. Lock in a lower interest rate now, even if you don't have outstanding debt.

3. Make big purchases now

The most recent increase in the federal funds rate was only 0.25%, but with at least six more predicted by the end of 2020, interest rates will only continue to rise. If you already know you're going to borrow money in the near future, and you're financially ready, go ahead and do it now.

There are still many credit cards offering 0% introductory APRs if your credit is good. These are a great way to pay off a major purchase, as long as you can pay off the balance in full before the introductory period ends. As mentioned above, these offers might not be around for much longer.

4. Switch to a fixed-rate mortgage

If you do have an adjustable-rate mortgage, now is a good time to think about refinancing into a fixed-rate mortgage. Locking in a fixed rate now will prevent your interest rate from rising with the federal funds rate, and it may give you some added peace of mind. However, remember that should the interest rate fall dramatically in the future, you will only be able to take advantage of it if you qualify for refinancing. Make sure you do your research, as fixed-rate mortgages aren't the best option for everyone.

Don't rush into any financial decision out of fear. While interest rates are likely to rise for the next couple of years, no one knows what they'll be doing 10 or 20 years from now. The best advice in almost any financial situation is to keep your mind on the long run.

5 Simple Tips to Skyrocket Your Credit Score Over 800!Increasing your credit score above 800 will put you in rare company. So rare that only 1 in 9 Americans can claim they're members of this elite club. But contrary to popular belief, racking up a high credit score is a lot easier than you may have imagined following 5 simple, disciplined strategies. You'll find a full rundown of each inside our FREE credit score guide. It's time to put your financial future first and secure a lifetime of savings by increasing your credit score. Simply click here to claim a copy 5 Simple Tips to Skyrocket Your Credit Score over 800.

Elizabeth Aldrich has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.