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Fed rate increases - Let’s go for a hike…

Joel Frisch - January 21, 2016

Hiking shoes on hiker outdoors walking

Are you ready to conquer the great unknown? As you plan for a hike, reviewing a map can help provide insights into what is around the corner and how you need to prepare. Your financial journey is no different. Here at Prodigy, we want to make sure that you understand the impact of the recent Fed rate increases and what it means for your loan.

The Fed rate and the hike

The Fed recently increased rates by 25 basis points (Dec 16, 2015) in an attempt to slowly tighten monetary policy to ensure a stable economy. To better understand the impact on rates, we need to first understand why the Fed adjusts rates.

The Fed, or Federal Reserve System, is the central banking system of the United States and it helps the US government regulate the economy. The Fed is able to adjust the supply of money to stimulate or control economic growth.  We watched how the Fed pumped up the supply of money into the US system in 2008 to help drive growth. As more money entered the system, the price, or interest rate, decreased following the fundamental principles of supply and demand. This in turn promoted borrowing for expansion and investment.

As the US and international markets have rebounded from the challenges of 2008, the Fed is looking to slow the growth to prevent unintended bubbles and inflation.  Raising interest rates is one way that the Fed can restrict the amount of money available.

LIBOR Rate and the Prime Rate

As the Fed raises rates that US banks can borrow at, other benchmark rates are affected. Two of the most important benchmark rates for commercial loans are LIBOR (the London Interbank Offered Rate) and the Prime Rate.  LIBOR, which is the rate at which international banks lend to each other, is the industry standard for student loans.  LIBOR is not controlled by the Fed but does tend to track closely with any movements in the fed funds rate. The Prime Rate is used in 20% of student loans but tends to be more volatile.  Additionally, the general trend with Prime is to lag decreases in bank cost of capital but to immediately reflect increases. However, loans that are tied to 3-month LIBOR will usually take an additional two months to adjust to the changes in the index. While students with fixed rate loans will be unaffected by rate moves, benchmark adjustments will impact interest rates on variable student loans. This could lead to higher monthly payments.

Considering both paths

A fed hike is not something that you can control and therefore you should not panic. The Fed will typically make small incremental changes and the impact on variable consumer or student loans should be minimal in the near term. Based on past learnings, the Fed is expected to move very slowly with any continued rate hikes and will continue to give significant guidance on the gradual changes.

Additionally, the Fed Chair Janet Yellen has said that she is looking at a “quite gradual pace over the next few years.” While no one is able to accurately forecast future rate movement, we encourage all borrowers to pay attention to current market rates when making any financial decisions.

For many students, variable rate loans will continue to look attractive to those borrowers who want a lower initial rate loan and are willing to take the risk of any additional rate hikes.  As always, the team at Prodigy recommends that students exercise a full comparison of their options to understand what is the best solution for you.

And remember in order to stay on the right trail, always pack a map!

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