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The interest rates you pay on loans and credit cards do not factor into credit score calculations in any way. But the current climate of rising interest rates can affect your credit scores in several indirect ways. Here's what you should understand about interest rate hikes and your credit.
How Can Rising Interest Rates Affect Credit?
Interest rates cannot affect credit directly: Credit scoring systems such as the FICO® Score☉ and VantageScore® calculate scores using data in your credit reports at the national credit bureaus (Experian, TransUnion and Equifax). Credit reports do not track the interest rates on loans, credit cards or other accounts, so those rates cannot factor into credit scores.
While they do not have a direct impact on credit scores, rising interest rates can affect several factors that do influence credit scores. Because they can lead to higher cumulative charges on credit card balances and adjustable-rate loans, higher interest rates can affect:
- Your total amount of outstanding debt
- The amount of minimum monthly payments on most credit card accounts and on mortgages and personal loans with adjustable interest rates
- Credit card utilization rate, or the percentage of your credit card limit with a balance
When payment requirements on household debts increase, there's less money available for savings and other expenses. If that means resorting to paying the bare minimum on credit card debt, it can lead to significant interest costs over time. Even worse, if tight budgets lead to late or missed debt payments, your credit scores will suffer. Unpaid bills can eventually lead to accounts being turned over to collection agencies, repossession of vehicles, and even the possibility of foreclosure and bankruptcy.
Which Credit Accounts Can Be Affected by Rising Interest Rates?
Federal Reserve interest rate hikes won't affect charges or payment amounts on loans with fixed interest rates, such as most auto loans and student loans and many mortgages. If you have credit card accounts with fixed interest rates, they'll generally remain unaffected as well, but most credit cards issued in recent decades have variable interest rates.
Accounts that are likely to see impacts as a result of rate increases are those with variable or adjustable interest rates, including:
- Most credit card accounts
- Adjustable-rate mortgages (ARMs)
- Most home equity lines of credit (HELOCs)
Interest rates on variable-rate loans and credit cards are a function of two numbers: an index and a margin, both of which are identified in their loan or cardholder agreements.
- Index: The index is one of any number of well-known market interest rates, such as the prime lending rate, the yield on one-year constant-maturity Treasury (CMT) securities or the cost of funds index (COFI). Indexed rates tend to rise and fall along with the federal funds rate governed by the Federal Reserve.
- Margin: The margin is a fixed percentage, somewhere in the range of 1% to 5% depending on the loan type and the borrower's credit standing. At regular intervals (typically once a year on a specific date), the interest rate on an ARM resets to a rate calculated by adding the margin to whatever the index happens to be that day.
The variable rate on a credit card is recalculated the same way, by adding its margin to its index. But card rates typically reset more frequently, and may lag Fed rate hikes by as little as one or two months.
Loan and cardholder agreements spell out how and when these interest rate resets occur, and typically specify limits on how much rates can rise in a one-year period and over the life of a loan.
When the interest rate increases on a variable-rate loan, the increase is applied to the outstanding balance on your loan, which has two immediate consequences:
- The amount you owe on the loan increases.
- The amount of your monthly installment payment also increases.
A credit card rate increase is also applied to any outstanding balance, so unless the balance is zero, a rate hike has the following effects:
- The amount of that outstanding balance increases.
- Your required minimum payment increases.
- Credit utilization for that card increases.
The higher the amount of the outstanding balance on a given card, the greater the impact of these changes.
That could leave less money for other expenses, including payments on loans that don't have adjustable interest rates. Factor in higher inflation-related costs at the grocery store and gas pump, and you may find yourself doing serious belt-tightening.
If that means resorting to paying the bare minimum on credit card debt, it can lead to significant interest costs over time. Even worse, if tight budgets lead to late or missed debt payments, your credit scores could suffer. Unpaid bills can eventually lead to accounts being turned over to collection agencies, repossession of vehicles, and even the possibility of foreclosure and bankruptcy.
What Can You Do to Protect Your Finances From Rising Interest Rates?
If you're concerned that interest rate hikes will make adjustable-rate debt difficult to manage, consider these options:
- Get a debt consolidation loan. If you borrow a lump sum of cash at a fixed interest rate and use the proceeds to pay off credit cards, you can swap multiple variable-rate credit card bills for one predictable monthly payment. This approach can save on long-term interest charges and reduce your exposure to interest rate hikes.
- Refinance your ARM. Replacing an adjustable-rate mortgage with a fixed-rate mortgage could insulate you from the uncertainty of future rate hikes and subsequent related payment increases. You'll likely need to pay closing costs on the new loan, and rates on fixed-rate mortgages are on the rise, so be sure you understand all the expenses before moving forward.
- Take advantage of an introductory 0% APR balance transfer credit card. Interest rates cannot increase on credit cards with zero-interest "teaser" rates until the end of their designated introductory periods—typically six to 21 months. Transferring balances from existing cards to a new balance transfer card can give you time to pay down your card debt without incurring the extra cost of higher interest rates.
- Seek credit counseling. If you start to feel overwhelmed managing your monthly expenses, seek help before you start sinking. An accredited credit counselor can help analyze your household cash flow and advise you on how to keep afloat.
- Maintain good credit habits. Whether or not any of the preceding strategies apply to your current circumstances, building and maintaining strong credit can give you options in times of economic uncertainty. To that end, do your best always to do the following:
- Pay your bills on time every month, without fail.
- Avoid running up high credit card bills, ideally keeping each card's balance below 30% of its borrowing limit.
- Take out new credit only when you really need it.
The Bottom Line
While rising interest rates don't affect credit directly, they can present challenges that make it harder to build and maintain good credit. Recognizing the potential impact of higher rates and planning accordingly can help protect and build your hard-earned credit. You can mark your progress by tracking your FICO® Score for free from Experian.