You’ve probably noticed the most visible impact of inflation: the rising cost of things you might want to buy. You’ve probably also heard about the Federal Reserve raising interest rates.
Why is the Fed doing this? And how are higher interest rates related to rising costs and inflation? And how does it all affect your personal finances?
Through its policies, the Federal Reserve aims to boost employment while keeping inflation low. By adjusting the federal funds rate, the rate at which commercial banks borrow and lend to one another—as well as the interest rate the Fed charges banks to borrow from it directly—the Fed works to influence interest rates for consumers and businesses in the marketplace.
Inflation is a measure of the rate of rising prices of goods and services in the economy. It typically results from an increase in production costs, a shortage of the supply of products or services, or an increase in demand for products and services. And inflation hit a 40-year high in early 2022, as gas prices, food, rents, and other costs jumped dramatically.1
That’s why the Fed is pushing interest rates higher, in an effort to slow inflation.
“Inflation becomes a problem when it is so high it exceeds the rate of wage growth,” said Tim Schmidt, Treasurer, Discover Financial Services, “and when it is unpredictable, which makes it difficult for consumers and businesses to plan for.”
The Fed’s moves may also indirectly affect the rate of interest you pay when you take out a loan. In times of low interest rates, the cost of borrowing money decreases. Conversely, higher interest rates—triggered by the Fed’s attempts to dampen inflation—make it more expensive to borrow money.
This article will explain the relationship between inflation and interest rates in a little more detail and give you some tips for dealing with inflation.
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How do rising interest rates impact consumers?
While you might think interest rates affect only those borrowing or lending money, they actually impact all consumers. When interest rates are low, people are more prone to spend because their money won’t earn much interest in a savings account, and they may choose to take out loans because their interest payments will be lower.
Consumers may also be motivated to buy more goods as prices rise with inflation, because they think prices may go up even more. And in periods of rapidly increasing inflation, prices do go up: The higher costs of gasoline, food, and utilities in North America in 2022 are a perfect example.
When interest rates are high, people are encouraged to save their money because it will earn them more in interest from the bank. Once inflation slows and prices stabilize, consumers may choose to put off a purchase because they don’t anticipate the price going up anytime soon. Some consumers may also see high interest rates and think it’s a good time to focus on saving toward financial goals, like a down payment on a home.
Consumers with fixed interest rate loans, which won’t immediately be affected by the Fed’s actions, often feel more confident in their ability to spend and borrow than those with variable-rate loans such as credit cards. This is one reason periods of inflation can be an ideal time to consider consolidating variable-rate debt, like credit card debt, with a fixed-rate personal loan.
What is the relationship between inflation and rising rates?
When interest rates are low, it’s less costly to borrow money. Cheaper borrowing helps people take advantage of opportunities 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 have access to the money they need to buy a car, the greater demand for cars may drive up prices.
This is inflation in action, and it’s why the Fed raises interest rates: to slow inflation and ensure prices don’t rise too steeply.
As mentioned in the previous section, consumers have less borrowing power when interest rates rise because the cost of borrowing increases. In this environment, there is less demand for goods and services, limiting inflation and helping prices to stabilize.
As interest rates rise, borrowing money costs more. So, if you have debt in the form of credit cards or loans, or are thinking about taking out a loan, it’s important to educate yourself about how you can manage the amount you pay in interest.
There are two basic types of interest rates: fixed and variable.
When you get a fixed-rate loan with fixed repayment terms, the interest rate will be set in stone for the entire term of the loan. A major benefit of this kind of loan is that you can calculate at the outset how much the total cost of borrowing will be. And when you have a set regular monthly payment, as with a Discover® personal loan, you’ll know exactly when the loan will be paid off.
The interest rate on a variable-rate loan will fluctuate throughout the term, partly based on what’s happening in the broader economy. Even if your minimum monthly payment remains the same, when the amount you’re charged in interest increases, less of your payment goes toward paying down the principal—which means you’re further away from paying off your debt.
How do rising interest rates impact borrowers?
When the Fed raises rates in an effort to curb inflation, you can expect to 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 become even more expensive in a rising rate environment.
That’s why it often makes sense to consolidate variable-rate debts from credit cards, store cards, higher-interest loans, and other bills into one fixed-rate loan. Consolidating your debts could allow you to pay less toward interest and make faster progress toward your other financial goals.
If you’re interested in seeing how much you might save in interest by consolidating higher-interest debt, you can use our debt consolidation calculator. In addition to potential savings, a loan for debt consolidation can simplify your financial life by offering one set regular monthly payment.
During a period of rising inflation and higher interest rates, you’ll want to look at the interest rates you’re paying, and understand whether they’re fixed or variable. If a big part of your monthly budget is going toward variable-rate interest, you might be able to take action to remedy this situation.
“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 expected to continue to rise, so now is a great time to consider a personal loan with a fixed interest rate and term, whether you need to consolidate higher-interest debt or pay for a large purchase.
That way you can lock in at a rate that fits your budget, and possibly enjoy lower debt payments and more money in your pocket—even if rates continue to rise in the future. Either way, when you’re armed with knowledge, you’re in a great position to preserve or improve your financial health.