As interest rates rise, will borrower prudence, too?

Interest rates have stayed so low for so long, consumers and investors may have forgotten what happens when rates go up. The Federal Reserve's rate boost Wednesday and prospects for 2018 increases may change mind-sets. 

Credit-card debt reached a new high earlier this year, topping the record set in 2008. And delinquencies are on the rise.

Like a small cloud on a sunny beach, a quarter-point hike in short-term borrowing rates arrived over the economy Wednesday.

The beachgoers are unlikely to notice. The Federal Reserve has already jacked up rates and the pace of economic growth has risen not fallen. The stock and housing markets are doing splendidly. Consumer confidence is at a post-2000 high and rising.

The interest-rate horizon has been sunny for so long – nearly a decade, in fact – that Americans may have forgotten what happens when interest rates rise. But with more rate hikes predicted for next year after a full percentage point rise since last December – the fastest jump since 2006 – it’s time for consumers and investors to adjust their thinking to a new reality.

Among the likely impacts of the new period:

  • Credit-card rates will rise, at a time when credit-card debt has rebounded from the Great Recession to reach record levels again and some borrowers are already showing signs of stress.
  • Some holders of student debt, those who took variable-rate loans as well as students taking out new loans, will take a hit.
  • Rates on auto loans and even mortgages are predicted to go up, albeit more slowly than more short-term debt. Auto loan delinquencies are on the rise.
  • Savings or money-market accounts may finally start offering interest rates that come close to matching inflation. But the stock market could grow more volatile.

What’s needed in this period or rising rates is not panic but prudence, economists and consumer-finance experts say.

“Consumers and investors both have the first instinct of protecting and maximizing their assets,” Jill Gonzalez, an analyst at consumer-finance website WalletHub, writes in an email. “This means that if interest rates go up, consumers will increase their savings since they can receive higher rates of return, and investors will be more inclined towards maintaining a diversified portfolio to counteract the volatility over time."

Of course, interest rates have stayed so low for so long that even economists are unsure what impact the expected rate-rise will have. Borrowing costs will still be lower than historic norms. The best guess is that impacts will be muted – for both consumers and investors. The temptation to move from stocks to fixed income will be there for some, yet yields will still be nothing to write home about.

Rate hikes and recessions

But finance experts also caution against complacency. A period of Fed tightening is not just about interest rates. It’s also about how well the central bank can do at regulating the economy’s monetary spigot. Economist Gary Shilling offers a blunt outlook in a new report.

“If the Fed persists in tightening, a recession is in the cards. By our count, in 11 of 12 post-World War II attempts by the central bank to cool the economy without upsetting the apple cart, a recession resulted. The only soft landing was in the mid-1990s,” Mr. Shilling writes.

For now, economists don’t see recession as a meaningful threat for next year. But some see the risk rising in 2019 if the Fed keeps tightening as expected.

All this can create uncertainty in the stock market. It’s also a reminder that the Fed’s steering of short-term rates doesn’t necessarily determine longer-term rates like those on mortgages or Treasury bonds. Marketplace forces are key. If bond-market investors are worried about a cooling economy, long-term interest rates can go down (or go up less) even when the Fed is raising interest rates.

“On average, a one percentage point rise in the [Fed’s short-term lending rate] leads to a 0.42% rise in 10-year Treasury yields,” Shilling explains.

Home buyers may face an uptick in mortgage rates, but economists note that over the past year the borrowing costs on a fixed-rate mortgage have edged down even as short-term rates have risen.

Nevertheless, if prospective buyers see an upward trend in mortgage rates, that could push some into action to purchase a home before rates go higher still, says Chris Christopher, executive director of US and global economics at IHS Markit near Boston.

Others could be priced out of the housing market entirely, he adds, in areas like New York City or San Francisco where prices are very high.

A credit-card hit

One of the first places consumers will see the impact of rising rates is on their credit card statements. Since December 2015, the Fed has driven rates up a full percentage point from near zero (not counting Wednesday’s increase) and credit card rates have moved up in lockstep, according to a WalletHub report released this week.

WalletHub estimates that those hikes cost consumers an extra $6 billion in credit-card interest this year. Wednesday’s increase will boost consumer costs another $1.46 billion in 2018, it says.

By contrast, interest rates on savings accounts and certificates of deposit have barely nudged up at all since the Fed began raising rates.

“If interest rates go up, people will come out of stocks and go into fixed-income investments,” says Shawn Lesser, co-founder of Big Path Capital, a socially oriented investment bank. But the interest rate “is so low that even if it moves up 1 percent, I don’t know how much of an impact it would have.”

The Fed has had interest rates very low before. The effective federal funds rate (which is the actual rates banks pay each other on overnight loans) dipped below 1 percent for three months in 1954 and again in 1958. It didn’t fall that low again until 2003 for one month. But in 2008, in a bid to stave off the financial crisis, the Fed slashed it below 1 percent, where it remained for 8-½ years.

Only in May have they edged above 1 percent. And the consensus among forecasters surveyed by the National Association for Business Economics is that interest rates will be near 2 percent by the end of 2018. That’s still low by historical standards, where the average over six decades is 4.9 percent.

Troubling signals

There are already signs of strain. Although foreclosures have receded, delinquency rates among auto finance lenders are rising, especially for subprime borrowers, the Federal Reserve Bank of New York warned in a November report. Credit card delinquencies are up over the past year. College-loan troubles have been mounting along with the debt itself.

When surveyed 1,000 adults about why they had accumulated credit-card debt, 42 percent said "making ends meet."

At some point, interest rates could get so high that consumers would have to change their spending habits.

“There certainly should be a tipping point,” writes Ms. Gonzalez of WalletHub. At the start of the Great Recession “in 2007, that was about $8,400 of credit card debt per household, which we're almost back to hitting again. However, since unemployment is at a 17-year low and consumer confidence is high, I see no signs that consumers will rein in spending any time soon."

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