The Federal Reserve System (also known as the Federal Reserve or simply the Fed) is the central banking system of the United States of America. The Fed hiked its benchmark short-term interest rate a quarter, from 1.75% to 2%.
Why is This Important?
Additionally to this increase, the FED raised its forecasts for both economic growth and inflation. Thus it expects to increase the rate two more times before 2018 ends.
So if we have an increase of 0.25% in both times, we’ll end with an interest rate of 2.5%.
- Debt issued from now on, with everything else equal, will be more expensive (individuals and companies);
- The return for your parked cash will increase;
- Therefore investments in more riskier assets such as stocks will be less attractive.
Household Debt and Credit Report
According to the New York Fed, the Household Debt continues to climb in the second Quarter of 2018. The total value reached a new peak, rising by $82 billion to reach $13.29 trillion.
The largest contributor to this value is Mortgages, with a total value of $9 trillion. Auto loan debt also reached an important value of $1.24 trillion.
Never forget, when interest rate rises, the cost of loans also rises. New debt and already existing debt with floating rates will rise accordingly.
For example, for a $13.29 trillion debt with a 1.75% interest rate, you will pay 232575000 in interest in that year. This means over $232 million in interest. In this theoretical and simplified example, if in the next year for the same amount you’ll pay a 2.00% interest rate this means 265800000. Over $265 million only in interest.
For the same total household debt, you’ll have an increase of 33225000. $33.225 million due to this decision from the Fed.
What Should We Do?
It depends if you’re an investor or an individual with a lot of debt (mortgage+auto loan) for example. It also depends if you truly believe that inflation and higher interest rates are coming in the next years.
When a central bank increases the interest rate the key objective is to fight inflation, to reduce spending and to stimulate saving. So if we do see less spending that could mean less demand for things that companies produce. Hence less probability of increasing/maintaining a high level of profits.
Additionally, companies (like individuals) will have more difficulty to borrow money at decent costs. Therefore that could damage their capability to invest in new projects, factories, and so on. Or even to refinance their own debt.
On the other hand, cash/certificate of deposits could turn out to be more attractive since the rate associated with this products will increase.
A person, country, or organization that owes money, will now have to pay more for the same debt. If it continues to increase, the difficulty to repay that money (in interest) will also increase.
One way to tackle this is simply to reduce the money that you owe. Reducing or even repaying in full the debt that someone owes is key to have financial independence. Thus and eventually a major contributor for early retirement.
And you reader? What do you think is the best path going forward in a rising interest rate environment?
Household debt as a share of GDP. (Source)
South Korea: 94%