What High Interest Rates Mean For Your Financial Health

TL;DR

• Inflation is high because COVID saw an increase in many people’s financial resources and a prolonged decline in spending. Post-isolation, people were desperate to get out and so spending dramatically increased. Businesses could charge more for things because demand was so high.
• Housing prices also increased because of low supply, high demand during COVID as people spent more time at home, and low interest rates making monthly housing costs somewhat more affordable.
• If inflation gets out of hand, people can no longer afford basic necessities and businesses struggle to get funded.
• Thus, the Fed intervenes by increasing interest rates. This means that any kind of debt is more expensive and saving is more advantageous, so people’s spending decreases.
• High inflation and interest rates mean a few things for you:
  • Avoid taking on new debt and pay down high or variable interest rate debt.
  • Increase your credit score to lower the cost of any debt you do have to take out.
  • Create a budget.
  • Save your money in places that are earning pretty high returns right now, like high yield savings accounts, CDs, money market accounts, or treasury bills.
  • See below for resources and definitions on all of these things.

There’s a good chance you’ve noticed how high interest rates and inflation are relative to a year or, especially, 2 years ago. However, you may not totally understand why that’s the case or what to do about it. To explain, I’ll brush off my dusty Economics major. Side note, if you have 0 interest in how high inflation rates and interest came to be and just want to know how it impacts you and what to do, scroll down to the header “What do high interest rates mean for you.”

Table of Contents

Why are we in a high-inflation period?

So why are interest rates rising? The Fed is increasing interest rates because of inflation. And inflation is so high, in large part, because of COVID. Remember all those stimulus checks we got? Or how we couldn’t do anything for basically 2 years? And how a lot of employees saw big salary increases because the labor market was so tight? And, oh yeah, how it was impossible to get everything from toilet paper to dressers? Basically a lot of people saw an increase in their financial resources, a decline in their spending, and a decline in the availability of products they did want to buy during peak COVID years.

Once COVID-related restrictions were lifted, people were desperate to get out and travel, eat at restaurants, hang out with friends, and basically spend a bunch of money. Businesses noticed that demand was up post-COVID. As a result, they raised prices. However, people were still so desperate to get out and do things, that raised prices didn’t deter people very much, so businesses raised prices more.

On top of this, those COVID-era supply-chain issues have persisted, though generally to a lesser degree, in some industries. Plus, the high cost of gas, transportation, and rents has meant that the cost of producing goods and selling them increased.

Combine all of this, and a new period of inflation was born.

The Role of the Housing Market

Something somewhat similar happened in the housing market, though for slightly different reasons. A lot of people were working from home throughout COVID. And they realized that their current living situations were just not cutting it. They started looking around at housing and noticed that interest rates were crazy low, which meant that the monthly cost of mortgages were pretty reasonable, even if the house prices themselves were not so reasonable.

So housing demand skyrocketed. House prices reached practically stratospheric levels and bidding wars became an almost universal practice. Home-building couldn’t keep up, in part because of COVID and high prices. Employment in the construction industry also still hasn’t recovered post the 2008 housing crash. As a result, the housing supply was and has been crazy low. This further pushed up prices for the houses that were on the market.

The Fed gets involved to avoid disaster (hopefully)

All of this meant that inflation started to get out of hand. When inflation gets out of hand, the Fed gets involved. Why?

Once inflation gets too high, people struggle to afford even basic necessities. Plus, as the value of money increases, the value of saving decreases. To put it more basically, say eggs cost $4 today but they’ll cost $5 tomorrow. If you need eggs, you should buy them today. If you wait, you’ll be able to buy less with your money. This can make it more advantageous to spend rather than save your money. Unfortunately, however, lots of spending further drives up prices. It’s a classic Catch-22 (one of my least favorites books ever BTW).

This has implications for consumers but also for businesses. It’s harder for businesses to get loans if it’s more valuable for individuals, businesses, and banks to spend money rather than loan it out.

We’re like Icarus flying too close to the sun. If we were rational beings that realized our wings were starting to melt (economy starting to get out of hand) and so reduced our height (spending) little by little, we’d avoid disaster.  But instead, we have a tendency to neglect those melting wings, rocket towards the sun, and then plunge to the Earth once our figurative wings totally melt off.

So this is why the Fed needs to intervene and increase interest rates well before people can no longer afford necessities and businesses struggle to stay funded.

Why does the Fed increase interest rates to deal with inflation?

The Fed increases interest rates because it makes any kind of debt more expensive, whether it’s for houses, cars, credit cards, etc. This hopefully makes people really start to notice that prices are increasing and they can’t overstrain themselves financially. Demand for houses, cars, consumer goods, etc. goes down and, eventually, prices come down with it. That process takes a long time, however, and is sucky in the interim when prices are still high, the cost of debt is high, and wages are rarely keeping up.

By increasing interest rates, the Fed also makes saving money more attractive because the interest rates on things like savings accounts goes up. As a result, people are less likely to pull their money out of savings and spend it.

As the Fed has raised interest rates over the past year, inflation has come down, but not as much as we’d hope. Given that, it’s expected that the Fed will raise interest rates at least 1-2 more times before the end of the year.

What do high interest rates mean for you?

Avoid/Pay Down Debt

That’s the background behind why interest rates are rising. However, what does it mean for you? As noted above, it means that any kind of debt is more expensive right now. If it’s possible for you to be flexible, then waiting to buy a house, car, or other large purchase until interest rates come down will likely save you money in the long run.

The exception to this is if you can pay for any of these things in full and not worry about interest rates, in which case, go you! I promise that wasn’t meant to be sarcastic.

If you currently have debt with a high or variable interest rate (one that is not locked in and can go up or down), do your best to pay off your debt sooner rather than later. See my guide on paying down debt here. I also outline two debt payoff strategies in the table below.

Increase Your Credit Score

This is also a great time to assess your credit score. Your credit score is a partial determinant of how high your interest rate is. Given that, having a higher score will mean that you generally get a lower interest rate than someone with a lower credit score.

As an example, if you have an excellent credit score, generally considered a 780 or above, your mortgage interest rate (as of this writing) would be around 7.07%. If you have an average credit score of 698, your mortgage interest rate would be about 8.11%. This means you’ll pay $285 more per month for a $500,000 house if you put 20% down than someone with an excellent credit score. And if you have a fair credit score of 630, your mortgage interest rate would be 8.4%, translating to $367 more per month than a person with an excellent credit score. For tips on how to increase your credit score, see my post on this topic.

Start a Budget and Establish Savings Goals

Even if you do not have debt, inflation is still pretty high which means there’s a good chance you’re spending more on everyday goods like food and gas. Establishing a budget can be really helpful for getting a hold of your finances, figuring out where you can cut expenses, and making sure you’re still on track to meet your goals. You can see my post on how to create a budget here.

Finally, there is a silver lining to high interest rates. It means that there are a number of safe places to save your money and earn pretty high returns on it. During normal times, putting your money in a savings account or investing in CDs (certificates of deposit) is barely better than having your money in cash. However, high interest rates on debt also mean high interest rates on savings accounts, CDs, treasury bonds, and money market accounts.

This means that budgeting has a one-two punch, you can save money on the things you buy and earn higher returns on that saved money if you know where to put it.

Where to Save

If you want to access your money at any time but still get a relatively high interest rate on your money, check out high-yield savings accounts (HYSAs). Many of them have interest rates between 3.5-5 percent.

If you do not need your money for 3, 6, 9 months or even a year or more, consider investing in CDs, money market accounts, and treasury bonds. These tend to have higher interest rates than HYSAs, though, again, you have to leave your money in them for a specified period of time. I outline the key definitions of each of these things below.  

For long-term saving, the stock market has always been king for beating inflation. While it experienced big dives last year, it has since recovered. Indeed, the stock market has always recovered from its declines. However, those recovery periods may take years. So again, the stock market is best for long-term savings (7+ years).

Money Market Funds

• Money Market Funds are a kind of bank deposit that pays interest based on prevailing interest rates and, similar to HYSAs, usually pays considerably higher interest rates than conventional bank accounts. There are usually minimum requirements for how much you deposit and you should always look for an FDIC-insured account to make sure you are protected from losing money. These accounts tend to be very safe and have few restrictions on withdrawing money.

Certificates of Deposit (CDs)

• CDs are time deposits. Basically you deposit money in a bank for a fixed amount of time, usually anywhere from 3 months to 5 or more years. Because you agree to give the bank that money for a fixed time, they often pay a higher interest rate than even HYSAs (depending on the time horizon) and that interest rate is fixed. There are penalties for withdrawing early, however, unless you purchase a No Penalty CD.

Government Bonds

• Government Bonds are basically a way for individuals to loan money to the government to help fund government spending. Treasury Bonds (T-Bonds), I-Bonds, T-Bills, and T-Notes are considered very safe as they are backed by the U.S. government. They generally return far less than the stock market, but more than HYSAs or Money Market Accounts. There are also often few restrictions on getting your money (though you must keep your money in I-Bonds for 1 years and if you withdraw before 5 years you lose 3 months of interest).

Summary

To sum up, high interest rates are probably here to stay at least through 2023 and potentially into 2024. Given that, a little planning and preparation are key. Do your best to avoid new debts and pay down the debt you already have. Improving your credit score can lead to better interest rates when you do need to take out debt. It’s a good idea to work on your credit score regardless of how interest rates are doing anyway.

Budgeting is also super key during this time. By saving money on the things you buy, you’ll be in a better position to pay down debt and/or save money and take advantage of the higher interest rates on things like savings accounts and CDs.

If you enjoyed this article, please consider liking, subscribing, or sharing with others, it’s always super appreciated! And remember that I am not a financial advisor, so make sure to consult with a professional before making any money moves.