The Federal Reserve, known as the Fed, raised interest rates for the 10th straight time on May 3. It’s possible this could be the last increase for a while, but at this point, your credit card debt is a lot more expensive than you ever expected.
I’ve been getting a lot of questions about how the Fed’s rate increases are connected to your credit card debt. Well, the eventual impact on your debt is the result of a chain reaction that starts when the Fed increases the federal funds rate.
Why the Fed Increases the Federal Funds Rate
The federal funds rate is a target rate that’s set by the Fed. It tells commercial banks what interest they’ll pay when they borrow and lend money to each other, usually overnight.
The Fed increases the federal funds rate when inflation is high. That’s why we’ve seen so many increases recently. The adjustments are an attempt to reduce inflation.
Increasing the federal funds rate then leads to an increase in the prime rate. And right there is the connection between the rate increase and your credit card’s annual percentage rate.
What Is the Prime Rate?
The prime rate is the interest rate that banks and financial institutions offer to borrowers who have very good credit. The prime rate is determined by the federal funds rate. Here’s a general rule about the prime rate: Banks often add 3 percentage points to the federal funds rate.
For example, the federal funds rate is around 5% to 5.25%. Based on the federal funds rate, the prime rate would be around 8% to 8.25%. But unfortunately, your credit card’s APR is likely much higher than the prime rate.
That’s because credit card issuers use the prime rate as the basis for setting their own rates. The issuer starts with the prime rate and then adds a margin. Note that rate policies range by issuer and by specific credit cards.
For instance, if the prime rate is 8.25%, an issuer might decide to add 13 percentage points to determine a credit card’s APR. In this case, the APR for that card is 21.25%.
Some credit cards have a range of APRs for a credit card, such as 18.25% to 27.25%. In this scenario, using 8.25% as the prime rate and adding a margin of 10 to 19 percentage points results in the card’s APR range of 18.25% to 27.25%.
Now, you’re ready to see the next link in the chain: How the prime rate increases make your credit card debt more expensive.
How the Prime Rate Impacts Your Credit Card Debt
If you had an APR of 21% before the latest 0.25-point Fed rate increase, then your new APR will be 21.25%. When the prime rate increases along with the Fed hike, it makes your credit card’s APR go up by the same amount. On the other hand, if the prime rate were to decrease, your APR would go down by the same amount.
This is why the Fed’s rate increases have made your credit card debt more expensive. Over the past year, the Fed’s rate increases have resulted in about a 5-point rate increase in your credit card’s APR.
For instance, if you had $10,000 in credit card debt with a 20% APR, you now have debt with a 25% APR. With compound interest, this increases your debt burden quite a bit.
Credit Card Debt: What to Do Next
Don’t panic if you haven’t made your debt a priority. But take time today to put a plan in place to pay off your debt. Knowing your credit score can help you decide which strategies are options for you.
For instance, you won’t get a 0% interest rate on a debt consolidation loan, but you might get a lower rate than what you have on credit cards. Another option is to get rid of debt the old-fashioned way: the debt snowball or the debt avalanche.
Though many swear by the debt snowball, I recommend the debt avalanche method in today’s economic conditions. You’re accumulating compound interest on your debt at a high APR, and you need to address that first.
But if you can’t bear to pull yourself away from the debt snowball, you can compromise with the debt blizzard, my own concoction. Start with the snowball method and pay off your smallest balance first. Then switch to the avalanche method and pay off your highest-interest balances.
As I said, don’t panic if you’re still at the starting line. Focus on what you need to do next to get in the race. Get started on your debt-free journey today, and before you know it, you’ll cross the finish line to financial freedom.