5 interest rate basics to know in advance of a Fed hike

The Federal Reserve could boost interest rates again before the end of the year. That move, when it comes, will affect almost everyone, in some way.

But a lot of the speculation about the Fed's next move likely has not reached millions of Americans.

Various surveys indicate that many Americans continue to struggle with financial literacy topics, including those related to interest rates. This hasn't stopped millions of people from using credit cards, taking out student loans and buying homes and cars with borrowed money, though it does help to explain why some people face debt problems.

What higher interest rates mean for consumers

A global survey conducted by S&P Ratings Services determined that only 57% of Americans are financially literate (though that was above the 33% average for people around the world). According to the study's authors, adults in this country "have a relatively weak understanding of interest, even though U.S. credit card use and student debt is among the highest in the world." Among the financial subjects examined, "interest is the least understood topic in the U.S.," added the report.

That's why it might be time to review a few interest rate basics in the context of a possible Federal Reserve action:

A Fed hike won't affect all interest rates.

There are many different types of interest rates, and they don't all react to the same things. The central bank exerts most control over short-term, variable rates such as yields on money market funds. By contrast, the Fed has little direct influence over long-term mortgage rates and rates on student loans and vehicle loans. Most of these rates are fixed and some, like  mortgages, respond to bond market prices, where inflation and inflationary expectations hold more sway. For example, most 30-year mortgage rates are pegged to yields on U.S. Treasury notes with 10-year maturities.

For consumers, the biggest impact could be felt in higher rates on credit cards, said Jacob Gold, a certified financial planner in Scottsdale, Ariz., and author of the book Money Mindset.

Some rates are influenced by debt issuers' financial health.

Another factor that affects rates is a borrower's credit condition. As a rule, people with poor credit histories, subprime borrowers, will pay more for a loan than others, reflecting the heightened concern that they might not pay their obligations. The same goes for corporations and governments that raise money by issuing or selling bonds. For shaky issuers, credit risk can greatly influence what yields they must offer to attract investors.

That is, yields will be higher for issuers perceived as unreliable — investors will require more money to compensate for the added uncertainty. But when an issuer improves its financial situation, the yields on its bonds will drop. At any rate, credit risks, rather than just interest rate movements, also affect yields.

Rate hikes aren't necessarily bad for consumers.

The impact from a Fed rate increase will vary. Some borrowers might not like paying higher interest, but others won't be affected. Savers will actually benefit. Yields have been depressed for years on certificates of deposit, money-market funds, Treasury bills and the like. As interest rates begin to slowly creep higher, "so will the yields of these investments," Gold said.

Curiously, rate hikes might help lenders, too. Rates currently are so low that banks earn an exceptionally meager differential between what they collect on loans compared to what they pay on deposits. "A low interest rate environment compresses the spread," said Rob Nichols, CEO of the American Bankers Association. As rates rise, those spreads will widen.

Incidentally, there are reasons to keep money in deposit accounts — even those paying little or no interest — compared to, say, keeping it under a mattress. One key reason concerns protection. "Even in a non-interest account, the money is better off in a federally insured financial institution, where you are fully protected from loss, than keeping it in the home, where it is more susceptible to fire, loss or theft," said Greg McBride, chief financial analyst at Bankrate.com.

In general, FDIC insurance covers up to $250,000 per depositor per bank. But by spreading money among banks, and possibly using additional titling arrangements, you can stretch the protection well beyond that.

Rate hikes aren't necessarily bad for stocks, either.

Higher interest rates are mostly bad for bonds, especially if they come with the expectation for higher inflation. As a rule, rising rates translate to lower bond prices — investors will bid down the prices of existing bonds in the market until their yields rise enough to correspond with newly issued bonds carrying higher yields. In other words, bond prices move in the opposite direction of rates.

With stocks, the relationship is less clear-cut. If rising rates correspond with a strengthening economy, that usually means corporate profits, revenue and cash flow are improving. Stock prices often advance under such conditions, especially if the rate hikes are gradual and start from low levels.

It follows that rate increases don't necessarily cause recessions. The overall impact to the economy this time around, assuming the Fed boosts by just a quarter percentage point or so, as is widely anticipated, should be minimal, Gold said.

Consumers don't need to pay a lot of interest to build good credit records.

There's a lot of misunderstanding about the factors that affect credit scores. For instance, some people worry about closing little-used credit card accounts that they've held many years, out of concern that this will lower their scores. While it's true that length of credit history is one variable that goes into the credit score mix, it's not major. The biggest determinant is consistently paying your bills and debts on time.

McBride cites another misconception: Many people seem to think they must pay a lot of interest to build good credit, he said. But there's no need to carry a credit card balance and incur finance charges each billing period. "You can build your credit just fine — and much less expensively — by paying the balance in full every month," he said.

Reach the reporter at russ.wiles@arizonarepublic.com or 602-444-8616.