How does the Federal Reserve impact credit card interest?

Written by
Bill Gilman
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As American consumers deal with inflation rates (8.3% as of August 2022) not seen since 1981, the Federal Reserve has taken aggressive steps to bring the economy back into balance.

In September, the Fed increased its benchmark Federal Funds Target Rate by 75 basis points (.75 percentage points), which matches its June and July rate hikes. It marked the fifth significant rate hike this year and additional increases are predicted.

At a press conference in August, Federal Reserve Board Chairman Jerome Powell said getting inflation under control remains a top priority.

“We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored,” Powell said. “We will keep at it until we are confident the job is done.”

Clearly, Powell and the Federal Reserve are making good on that August statement.

While interest rate hikes may help control inflation, there are unpleasant trickle-down side-effects, including increased Annual Percentage Rates (APRs) on credit cards.

“The rise and fall of interest rates directly impact consumers in borrowing costs and return on savings and investment accounts,” explains Linda Simpson, a professor of financial literacy in the Department of Human Services at Eastern Illinois University. “The rates can also be a predictor of future economic and financial market activity.”

So, what can consumers expect to see in their credit card statements and how can they mitigate ongoing interest rate hikes?

Before we dig more deeply into this question, here are some terms to know.

Federal Reserve (Fed) – In simplest terms, the Federal Reserve is the central bank of the United States. Overseen by a governing board, the Fed sets monetary policy with the goal of promoting fiscal stability. While the Fed has many functions, the one most visible to the public has to do with setting
interest rates. The Fed sets the Federal Funds Target Rate, raising interest rates to ease inflation or lowering rates to stimulate economic growth.

Federal Funds Target Rate – Set by the Federal Reserve, this is the interest rate banks charge to borrow and lend their excess reserves to each other, overnight. Changes in this rate set off a chain reaction through the financial world, which directly impacts consumers’ wallets.

Basis Points – This is a financial industry term that can cause some confusion in the public. A basis point is equal to 1/100th of 1%. So, when the Fed announces it is raising the Federal Funds Target Rate by 75 basis points, that means it is raising the rate by three-quarters of a percent (.75%).

Prime Rate – The Prime Rate is the interest rate banks charge their best (most trustworthy) customers to borrow money. This rate is primarily reserved for corporate clients that are least likely to default on loans because of their extensive financial resources. The rule of thumb is that the Prime Rate is equal to the Federal Funds Target Rate plus 3%.

Daily Periodic method – The Daily Periodic rate is calculated by taking a credit card interest rate and dividing it by 365. It is used to calculate one day of interest on a credit card balance.

FOR EXAMPLE

If the Annual Percentage Rate (APR) is 17.5%, the Daily Periodic Rate = .048%. Let’s say the credit card balance is $2,000. The Daily Periodic Rate of .048 would result in a daily interest charge of $0.96. The next day, the balance would be $2,000.96 and the daily periodic rate. It should be noted that some companies use 360, rather than 365.

Monthly Periodic method – Similarly, the Monthly Periodic rate is calculated by dividing the APR by 12.

FOR EXAMPLE

Using that same APR of 17.5%, the Monthly Periodic rate would be 1.45%. Using the Monthly Periodic method and the same $2,000 balance, the interest charge for the month would be $29.17. The new balance would be $2,029.17.

APR margin– Think of an APR margin as the credit card company “mark-up.” It is the percentage rate a credit card company adds to the Prime Rate to come up with the APR it charges cardholders. This “mark-up” varies from customer to customer depending on their credit worthiness. A credit card company provides its APR range in its official disclosures.

Now that we have some basic terms in mind, let’s talk about why the Federal Reserve raising interest rates can have an immediate impact on consumers’ wallets.

Where are we and how did we get here?

In 2020-21, as America and the world battled the worst of the Covid-19 pandemic, the Fed kept its Federal Fund Target Rate at or near 0%. The goal? To stimulate investments and the overall economy to offset the pandemic-related economic shutdowns.

Earlier in 2022, as the nation’s economy continued to rebuild, inflation (driven by huge increases in energy costs) began climbing to levels not seen in decades. The Fed responded by increasing its benchmark rate by 25 points in March and 50 points in May. Consecutive 75-point increases followed in June and July, bringing the Federal Funds Target Rate to 2.50%.

These increases have resulted in the Prime Rate jumping from around 3% at the start of the year to 5.5% on July 31. In turn, banks have passed the 2.5% increase on to credit card users (and really anyone borrowing money right now)

Most experts expect increases to continue throughout 2022 and into 2023.

How do these rate hikes impact consumers’ wallets?

Let’s take a look at how the most recent Fed rate hikes impact a hypothetical consumer with excellent credit carrying a $3,000 credit card balance.

March 2022

  • Federal Funds Rate = 0.50%
  • Prime Rate = 3.50%
  • APR margin = 11.74%-20.49%. Our hypothetical cardholder has excellent credit, so they’ll be on the lower end of that range, meaning 11.74%.
  • Credit card interest rate = 11.74% + 3.50% = 15.24%
  • Credit card balance = $3,000
  • Interest charged = $36 a month

August 2022

  • Federal Funds Rate = 2.50%
  • Prime Rate = 5.50%
  • APR margin = 11.74%-20.49%. Our hypothetical cardholder has excellent credit, so they’ll be on the lower end of that range, meaning 11.74%.
  • Credit card interest rate = 11.74% + 5.50% = 17.24%
  • Credit card balance = $3,000
  • Interest charged = $40 a month

KEY POINT

The increase of 2 percentage points in the Federal Reserve Funds Target Rate results in an increase of 11% in actual interest charges. Remember, too, that those monthly charges can simply increase each billing cycle as the previous month’s interest charges figure into the new balance.

What ISN’T affected by the Federal Reserve rates?

The Federal Reserve’s interest rate changes don’t affect all the rates and fees related to credit cards. In general, interest rates hikes do not affect annual fees, foreign transaction fees, late payment fees, cash advance fees or balance transfer fees. Additionally, the Federal Reserve’s actions do not directly affect rewards earning or redemptions. Of course, banks can always choose to respond to the economic times and change their rates and fees (within the confines of legal guidelines), but the Fed’s hikes won’t automatically trigger updates.

What can be done to combat rising rates?

The trickle-down effect of Federal Reserve rate hikes could certainly cost credit card holders, but there are simple steps to help mitigate the impact on consumers’ wallets.

Pay off credit card balances as quickly as possible – If possible, pay off credit card balances in full each billing cycle – no balance, no need to worry about interest rates. Remember, the Fed has signaled there are more rate hikes to come, so this is not the best time to carry debt.

Make timely payments – Cardholders who can’t pay the balance in full should make sure they make at least the monthly minimum payment on time. That will avoid late payment fees, which increase the total card balance and contribute to snowballing interest, and avoid a penalty interest rate hike that could mean paying even more.

Consider strategic balance transfers – The best balance transfer credit cards offer introductory 0% interest periods ranging from a few months to well over a year. Cardholders can avoid interest charges – and the impact of rate hikes – by transferring balances to a card with a 0% APR offer and paying off the debt before that intro period ends. This can result in huge savings as long as the balance is paid off within the introductory offer time frame; once the offer ends, the interest rates can be very high

Spend conservatively – “Prudence” and “discretion” are the keywords when it comes to spending. Revisit the family budget and look for ways to to reduce spending. This may also not be the best time to take on a major purchase.

Build a savings account – As spending is reduced, consider building a savings account. Maintain a robust emergency fund, equal to six-month’s salary at least. While there are different definitions of an emergency fund, another approach is to save enough money to cover six months of expenses in case of a job loss.

BONUS TIP!

Fed hikes could positively affect the interest rates banks pay on savings accounts. Experts have predicted the Annual Percentage Yield (APY) on savings accounts could reach 2% by the end of the year. Consider shopping around for a “high-yield savings” account.

Boost your credit score – Take advantage of the free credit reports available through annualcreditreport.com and look for the ways to increase credit scores. Boosting scores can significantly impact the interest rates a consumer pays on future credit cards, bank loans and mortgages.

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