What interest rate hikes could mean for personal loan borrowers – Forbes Advisor

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Personal loans are a popular and easy way to pay for larger expenses such as moving, home renovations, weddings, and even emergencies. They’re also handy for consolidating your high-interest debt, such as credit cards, at a lower rate that will help you save money over time.

The amount you pay for personal loans depends on several different factors, including your credit score and history, your income, and the federal funds rate.

What is the federal funds interest rate?

The federal funds rate is the target rate that the Federal Reserve sets for banks to lend to each other overnight. Banks lend to each other every night because they need to keep a certain amount of money in the bank and available for people to withdraw the next day, also known as reserves.

Every day, some banks may have more or less than they need for their reserves, depending on how people have deposited or withdrawn money during the day. By lending money to each other overnight, at the target interest rate set by the Federal Reserve, they can ensure that they meet their reserve requirements.

The federal funds rate is the first tipping point in a long series of dominoes that ripple through and impact the entire economy, including you, in other ways. For example, because the federal funds rate helps determine the cost to banks of exchanging money, banks pass it on to you when you need a loan. The higher the federal funds rate, the more they charge you for a personal loan, and vice versa.

How is the federal funds rate determined?

The federal funds rate is set by the Federal Open Market Committee (FOMC), a group of 12 senior members of the Federal Reserve System. They change the federal funds rate in an attempt to move the economy in certain directions. For example, if inflation is higher than they would like, they can raise the federal funds rate to try to curb inflation.

A point that is often confusing is that the FOMC sets a range of rates, which are more like targets. Banks are free to choose the rate they want to lend to each other within this range. The rate at which banks actually lend money to each other is called the effective federal funds rate.

How the Federal Funds Rate Affects Personal Loan Rates

Although the fed funds rate is a bit of an arcane monetary policy, it does affect you. This is because of how it plays into your overall personal loan costs, among other loan products.

Each personal lender sets their own range of interest rates they can charge. The lower interest rates are usually reserved for highly qualified applicants, while the higher rates usually fall into the hands of people with weak or damaged credit.

Most lenders base their interest rates on an index, such as the prime rate. For example, they can set their lowest rate at prime plus 3%. If the prime rate is 3.25%, that means you will be charged 6.25%.

These indexes are themselves based in part on the federal funds rate. As the federal funds rate rises, the indexes also rise, which also causes personal loan interest rates to rise.

Fluctuations in the federal funds rate are like a cascade of dominoes that ultimately accrue to you, the borrower.

Impact of interest rates on the cost of borrowing

Interest rates play a key role in personal loans because they determine how much it costs you to borrow money and how much you owe monthly.

Take, for example, SoFi, which offers personal loan rates starting at around 5% annual percentage rate of charge (APR). Here’s how much it would cost to take out a four-year, $5,000 term loan at three different rates:

Federal funds rate forecast for 2022

The effective federal funds rate has been about as low as possible since April 2020, hovering around 0.08%. The latest minutes from the FOMC meeting in December indicate that they will raise rates, and at a faster pace this year.

According to Federal Reserve, the median where FOMC members and Federal Reserve bank presidents think rates will go forward is 0.9% in 2022, 1.6% in 2023, and 2.1% in 2024.

Another question is when these rate hikes will take place. The FOMC meets eight times in 2022 and could raise the Federal Reserve rate at any of those meetings. According to the CME group FedWatch Tool, the most likely times we will see a rate hike could be at the following meetings:

  • March 16
  • June 22
  • July 17
  • December 22

At the end of the line

The federal funds rate is one of the levers the Federal Reserve uses to tinker with the economy. Specifically, it is the rate banks use to lend each other money each night to ensure they meet reserve requirements. This affects you as a borrower because banks take the federal funds rate into account when setting interest rates for their products, including personal loans.

If the federal funds rate increases, as expected in 2022, you will have to pay a little more to borrow money. If you wanted to consolidate debt or finance a big purchase, now might be a good time to apply for a personal loan if you can, before rates go up.

Related: Best Low Interest Personal Loans

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