You have probably noticed the rising cost of groceries, gas, and cars. Maybe you also recall hearing about the Federal Reserve (“the Fed”) raising interest rates several times in recent years.
Why do interest rates go up when inflation is high? And how does it affect your personal finances?
The short answer is that when inflation is high, the Fed raises interest rates to encourage people to spend less and to help drive down prices. In this article, we lay out what you need to know about the relationship between interest rates and inflation.
Table of contents
Why do interest rates go up when inflation is high?
One of the Fed’s mandates is to keep inflation low. When inflation is too high, the Fed raises interest rates to encourage consumers and businesses to spend less and to drive down prices.
The idea is that if consumers spend less there will be less demand for goods and services and that will lead to lower prices.
Inflation hit a 40-year high in the middle of 2022 when gas prices, food, rents, and other costs jumped dramatically.1 That’s why the Fed raised interest rates in 2022 and the first half of 2023.
“Inflation becomes a problem when it is so high it exceeds wage growth and when it is unpredictable, which makes it difficult for consumers and businesses to plan for,” said Tim Schmidt, Treasurer, Discover Financial Services.
Why does increasing interest rates decrease inflation?
When interest rates are low, it costs less to borrow money. Cheaper borrowing helps people make bigger purchases like buying a car or paying for a home renovation. But this increase in the availability of money can also lead to higher prices.
For instance, when more people can afford to borrow the money they need to buy a car, the greater demand for cars may drive up prices.
When the Fed raises interest rates to combat inflation, the cost of borrowing money increases. As a result, spending decreases, which limits inflation and helps stabilize prices.
Fixed vs. variable interest rates
There are two basic types of interest rates: fixed and variable.
Fixed interest rates
When you get a fixed-rate loan with a set repayment term, the interest rate will be locked in for the entire term of the loan regardless of whether the Fed raises rates.
A major benefit of this kind of loan is that you will know in advance how much the total cost of borrowing will be. And when you have a set regular monthly payment, you’ll know exactly when the loan will be paid off.
Variable interest rates
The interest rate on a variable-rate loan can fluctuate throughout the loan term depending on whether the Fed changes interest rates because of what’s happening in the broader economy.
Even if your minimum monthly payment remains the same, less of your payment goes toward paying down the principal if your interest rate increases—which means you are further away from paying off your debt.
How do rising interest rates affect you?
When the Fed raises rates, you might pay more if you have a variable-rate line of credit, credit card, or other variable-rate loan. In particular, credit cards often have higher variable rates, which can become more expensive if interest rates rise.
That’s why it can be a good idea to consolidate variable-rate debt into one fixed-rate loan. You might save money on interest and even pay off debt faster. In fact, 89% of surveyed debt consolidation customers told us they paid off existing debt sooner with a Discover® personal loan.*
If you’re interested in seeing how much you might save on interest compared to a higher-rate loan, you can use our debt consolidation calculator. A loan for debt consolidation could also simplify your finances with one set regular monthly payment.
What is the best way to combat rising interest rates?
The first step is to look at the interest rates you’re paying to see if they’re fixed or variable.
“Always begin by taking stock of your financial objectives, obligations, and resources. Then you can use that information to decide how much to borrow, how long to borrow, and what payments you can afford,” said Schmidt. “If you’re unsure how to do this, you may want to consider getting help from a qualified financial advisor.”
Interest rates are not expected to decrease until 2024,2 so now is a great time to consider a personal loan with a fixed rate and term.
That way you can lock in an interest rate that won’t change for the life of the loan, no matter what happens in the broader economy.
Either way, when you’re armed with information, you’re in a great position to keep your finances on track.
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