If the Fed Raises Rates, What Happens to Your Loan?

If you’ve paid any attention to financial news lately, you may have noticed a familiar four-letter word making its way back into the conversation: hike.

After months of holding interest rates steady, the Federal Reserve is once again openly discussing the possibility of raising rates if inflation doesn’t continue moving in the right direction.

So, naturally, consumers may be wondering: If the Fed raises rates, does that mean my borrowing costs are going up, too? The answer—because apparently nothing involving interest rates can ever be simple—is maybe.

First, it helps to understand what the Federal Reserve actually controls. The Fed doesn’t set your mortgage rate, auto loan rate or the rate your local bank charges you. Instead, it establishes a target range for the federal funds rate, which is currently 3.50% to 3.75%. That’s a very short-term rate involving overnight transactions between financial institutions.

But changes in that rate ripple through the financial system differently depending on what kind of loan you have. Some borrowing rates are closely connected to Fed policy. The prime rate, for example, typically moves with changes in the federal funds rate. Many credit cards, home equity lines of credit and other variable-rate loans are tied to prime. If the Fed raises rates by a quarter of a percentage point, borrowers with these types of loans could see their rates increase fairly quickly.

Fixed-rate mortgages are a different story. Thirty-year mortgage rates are influenced much more by longer-term financial markets, particularly Treasury yields and mortgage-backed securities. Those markets don’t wait for the Federal Reserve to officially make a move. Investors are constantly trying to anticipate what comes next.

That means if everyone expects the Fed to raise rates later this month, some of the effect may already be reflected in longer-term rates before the Fed ever votes. We’re seeing some of that right now. Longer-term Treasury yields have been rising amid concerns about persistent inflation, government borrowing and expectations for tighter Fed policy. Those higher market yields can put upward pressure on mortgage and other longer-term borrowing rates regardless of whether the Fed ultimately raises its overnight rate at its next meeting.

So what should consumers do? First, don’t make a major financial decision based solely on predictions about what the Fed might do. Economists and financial markets spend enormous amounts of time trying to predict interest rates—and they still get it wrong. Instead, focus on what you can control: the amount you borrow, your credit quality, your down payment, the term of the loan and, most importantly, whether the payment comfortably fits your budget.

And if you already have a fixed-rate mortgage or auto loan? You’re safe.

The bigger lesson is that when you hear “the Fed may raise rates,” don’t automatically translate that into “my loan rate is going up.” Sometimes it will. Sometimes the market already beat the Fed to it. Understanding the difference can make you a much smarter borrower.