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To battle inflation, the Federal Reserve raised interest rates seven times in 2022 and twice in early 2023. Although increases are getting smaller, the Fed has signaled it will likely keep hiking interest rates this year. Escalating interest rates make borrowing more expensive, but there's also good news: Rising benchmark interest rates can help your savings earn more money. Here's how increasing interest rates can benefit your bank account.
How Fed Rate Hikes Impact Savings
Savings accounts typically have variable interest rates, meaning the interest you earn can change with benchmark federal interest rates. Some key terms to know include:
Federal Funds Rate
Banks borrow cash reserves from each other overnight so they have enough funds to meet their obligations. The federal funds rate, or fed rate, is a percentage banks use to determine the interest rate they charge each other for borrowing money. As of early March 2023, the fed rate was 4.57%. The fed rate also affects the interest rates financial institutions pay account holders for deposit accounts.
Prime Rate
The prime rate is a percentage lenders use when deciding how much interest to charge consumers for borrowing money. Typically, lenders add 3% to the fed rate when setting the prime rate. If the fed rate rises, then banks, credit unions and credit card companies raise their interest rates, which makes borrowing more expensive.
Annual Percentage Yield (APY)
APY calculates the amount an interest-bearing savings account could earn (or "yield") in one year. This differs slightly from the account's interest rate or annual percentage rate (APR).
APR represents how much you earn on your money without compound interest; APY includes compound interest. Because banks typically pay compound interest on savings accounts, money market accounts and certificates of deposit (CDs), they generally show an account's APY rather than APR. In some cases, APY and APR are nearly the same. The higher the interest rate, the greater the difference between the two.
Compound Interest
An account that pays compound interest pays interest on the interest you earn. Suppose you deposit $1,000 in a savings account with a 4.5% APY. In one year, you'll earn $45 in interest (4.5% of $1,000) and have a balance of $1,045. In the second year, you earn interest of $47.02 (4.5% of $1,045).
Exact compound interest earnings vary depending on how often interest is calculated—daily, monthly or annually. You can estimate the compound interest returns of different savings accounts using a compound interest calculator.
How to Take Advantage of High Rates
To benefit from rising interest rates, consider the following financial moves.
1. Open a High-Yield Savings Account
The average APY on a regular savings account was just 0.35% in February 2023, according to the Federal Deposit Insurance Corporation (FDIC). You can get more for your money with a high-yield savings account. While some savings account APYs are as low as 0.01%, you can find high-yield savings accounts offering APYs up to 4.25%. Online banks usually pay the highest APYs, passing on the savings from operating virtually to their customers.
Find High-Yield Savings Accounts
2. Open a Money Market Account
A money market account is a savings account whose APY is usually higher than a regular savings account, but lower than a high-yield savings account. In February 2023, the average money market account APY was 0.48%.
Unlike regular savings accounts, money market accounts may allow you to write checks. Because they usually have higher minimum balance requirements than traditional checking accounts, they're best if you have a substantial amount to deposit.
3. Open a Certificate of Deposit (CD)
CDs are savings accounts in which you deposit a set amount of money and earn interest until the account matures. A CD's term typically lasts from three to 60 months; longer terms generally mean higher APYs. Average interest rates were 0.97% for a six-month CD and 1.49% for a 12-month CD in March 2023. Unlike savings and money market accounts, CDs generally pay fixed interest rates, making them a good way to lock in higher returns before interest rates fall. The downside: Withdrawing the money before the CD matures typically incurs a penalty.
4. Pay Down Credit Card Debt
Most credit cards have variable interest rates significantly higher than the prime rate. As of November 2022, the average credit card interest rate was 20.4%. Carrying a balance on your credit card costs more as interest rates rise. Save money by paying down credit card debt with the debt snowball or debt avalanche method.
5. Work on Improving Your Credit Score
It's best to avoid borrowing when interest rates are high. Still, you never know when you'll find the perfect home for sale or face an unexpected expense that you need a loan to cover. Maintaining good credit expands your borrowing options. Paying down credit card debt, not applying for new credit and paying bills on time can improve your credit score, which can help you qualify for more favorable loan rates.
6. Step up Your Emergency Savings
With a solid emergency fund, you can avoid borrowing money or using credit to cover unanticipated expenses. Review your budget for ways to cut back on spending. If you're not already doing so, automate transfers into your savings account every payday so you'll never miss the money. Stashing your emergency fund in a high-interest savings account can multiply your money faster.
7. Refinance Variable-Rate Loans Into Fixed-Rate Loans
The APR on a variable-rate loan can change based on market interest rates, potentially throwing your budget off balance when interest rates rise. Personal loans, home equity lines of credit, private student loans and adjustable-rate mortgages may all have variable interest rates. Depending on your remaining loan term, refinancing into a new loan with a fixed interest rate may make financial sense.
Fixed-rate loan payments stay the same whether interest rates rise or fall, so it's easier to budget. Consider the total cost of borrowing, including fees, and be aware that if interest rates drop in the future, you may need to refinance again. Use Experian CreditMatch™ to shop for loans suiting your credit profile.
How to Find the Best Savings Rates
Options for savings accounts include traditional banks, online banks and credit unions. Shop around to find the best APY. Also consider the following factors:
- Minimum deposit requirements: Money market accounts and CDs typically require a larger initial deposit than regular savings accounts. Make sure you have enough funds to meet the bank's criteria.
- Bank fees: Compare fees, such as monthly maintenance fees, fees for transferring funds or fees for using ATMs, to make sure they won't wipe out your interest earnings.
- Safety: Check to make sure the bank is insured by the Federal Deposit Insurance Corporation (FDIC) or the credit union belongs to the National Credit Union Association (NCUA). Both organizations insure your deposits up to certain limits.
The Bottom Line
Maintaining good credit can keep you on firm footing despite a shifting monetary landscape. Check your credit report and credit score regularly, and take steps to improve your credit if necessary. The better your credit health is, the less impact ups and downs in federal interest rates will have on your financial well-being.