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In order to tamp down stubbornly high inflation, the Federal Reserve recently announced a third consecutive 0.75 percentage point rate hike in late September, further increasing the cost of debt for credit cards, auto financing, and other loans.
According to CNBC, “The fifth-straight increase to the federal funds rate brings it to a range of 3% to 3.25%, the highest it’s been since 2008. Typically, rate increases come in 25 basis point increments, but the Fed has been using supersized hikes to curb the rate of inflation, which is currently up 8.3% year over year — well above its benchmark target of 2%.”
Higher interest rates reduce disposable income (and therefore consumer spending), increase the cost of borrowing, hamper the speed of economic growth, and limit the rate of inflation.
Increased interest rates also increase the yield on financial institutions’ cash holdings. This creates a favorable environment for institutions to increase their profitability. Financial institutions should pay particular attention to how rising interest rates could affect their bottom lines in this fiscal environment.
Deposit Products
When interest rates are higher, banks and credit unions attract more deposits, and deposit products enjoy greater popularity among borrowers.
For example, according to The Financial Brand, when the federal funds rate was more than 5% in 2007, nearly 25% of consumers had a CD, but only 15% had one in 2017 when the interest rate was less than 2%. In 2007, 21% of consumers had a money market account, compared with 17% in 2017.
Savings Accounts
Financial institutions typically choose to raise the annual percentage yields (APYs) they offer on savings accounts when the federal interest rate increases. Although Fed rate hikes aren’t directly tied to savings account rates, they are one of several factors that could encourage banks and credit unions to increase their annual percentage yields.
Mortgage Interest Rates
Higher interest rates can lead to a rise in interest payments on variable mortgages. Even a relatively small increase of 0.5% in interest rate translates to more than $40 per month for a $100,000 mortgage. Fixed-rate mortgages are not affected by rising interest rates.
Auto Loan Rates
Auto loan rates are often tied to federal interest rates, so higher interest rates might see your financial institution raise rates on auto loans.
According to the Consumer Financial Protection Bureau, “Recent data shows that the rate of transition into delinquency, especially for low-income borrowers, has risen over the past year. This rise could simply be a return to pre-pandemic levels resulting from the end of pandemic-related stimulus policies. However, inflationary pressures could mean the costs of car ownership are outpacing income growth for some consumers with auto loans.”
Credit Card Rates
In Q2 2022, credit card usage rose an astonishing 13% quarter-over-quarter. Most credit cards are attached to a variable annual percentage rate (APR), which depends on the bank rate for any given year. An increase in interest rates elevates the APR for credit cards, which means that consumers have to pay more interest on their credit card debt.
As interest rates rise, charged purchases and payments that originally appeared manageable can become difficult for debtors to pay, especially as late fees and penalties are added.
For lenders, an increase in credit card delinquencies is an expensive proposition. According to the Federal Reserve, small financial institutions (defined as those with less than $10.5 billion in assets) experience the greatest impact from increased credit card delinquencies.
While some amount of default is expected, a financial institution can implement risk mitigation strategies, such as a payment protection program that protects a financial institution and customers from credit card default.
Delinquencies
In his Q3 Economic Outlook for Financial Institutions, SWBC’s Chief Economist, Blake Hastings, provided the following insights on rising delinquencies:
- Delinquencies are beginning to pick up as consumers feel the strain. According to Cox Automotive, auto delinquencies were up 30% year-over-year in May. Subprime auto loans more than 60 days past due are at 5.36% of total subprime loans, higher than their pre-pandemic levels.
- After several months of record lows, mortgage delinquencies rose in May by nine basis points to 2.84%.
- According to the software and data analytics firm Black Knight, the number of borrowers one payment past due rose 5% in May over April and even 90-day delinquencies picked up 1% after 21 months of decreases.
When facing increased nonpayment of your institution’s accounts, the best defense is a good offense. Document strict guidelines for extending credit and stick to them. Vetting credit applicants thoroughly and considering existing debt when extending new lines of credit is crucial.
In the face of rising interest rates and delinquencies, leveraging outsourced collection services can be an efficient, cost-effective option to minimize your collections queues and the time employees dedicate to the collections process.
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