How the Fed’s rate hikes affect credit cards

The Federal Reserve has dramatically raised interest rates in 2022 and, as a result, credit card interest rates are on the rise.

Credit card interest rates can change whenever the Fed’s benchmark interest rate changes, and most cards have a variable annual percentage rate (APR) — which makes them directly connected. When the Fed raises rates, credit card companies typically raise their rates as well.

If you carry a high balance on your credit card, this can be a significant burden, as you’ll have to pay more in interest each month.

Read on to learn more about how the Fed’s actions affect you as a credit card user, and what you can do to minimize the impact of rising rates.

Why is the Federal Reserve raising interest rates?

Among the Fed’s many duties is to regulate the money supply and set interest rates to influence other benchmark rates. The federal funds rate, for example, influences the rate for consumer loans, such as for credit cards and adjustable-rate mortgages.

The federal funds rate is the interest rate at which banks and other depository institutions lend money to each other, usually on an overnight basis.

When the federal funds rate is low, it’s cheaper to borrow, which can lead to increased spending and investment. This can in turn lead to higher wages and inflation.

When the federal funds rate is high, borrowing is more expensive and this can lead to increased savings, which can help keep inflation under control. Inflation has soared in recent years amid several factors, many of which were driven by the COVID pandemic.

The federal funds rate is 4.25 percent to 4.5 percent, after the Fed announced Dec. 14 it would raise interest rates by half a percentage point. It was the seventh rate hike of 2022.

How do rate hikes affect credit card interest rates?

The Fed’s target interest rate directly affects credit card interest rates because card issuers’ variable rates are based on the prime rate, which is in turn based on the Fed’s target rate.

The prime rate is the interest rate that banks charge their most creditworthy corporate customers for short-term loans. When the Federal Reserve makes a change to the federal funds rate, it does not affect the prime rate directly. Instead, the prime rate is based on the federal funds effective rate, which is one of the rates the Fed directly influences. The prime rate is used as a benchmark interest rate for many types of loans and credit products, including credit cards.

When the Fed raises its target rate, the prime rate goes up, and when the prime rate goes up, variable credit card rates soon follow. In the past few years, the Fed kept the federal funds rate near zero, so credit card interest rates have been low. But in 2022, the Fed has increased its target rate five times, which has sent the average credit card APR to record levels.

The final APR that a credit card issuer offers you will be based on a number of factors, including your credit score, credit history and income. And most credit cards have a grace period where you can avoid paying interest on purchases if you pay your balance in full each month by the due date.

However, if you carry a balance on your credit card, you will accrue interest at the APR, and it will take longer to pay off your debt.

If your card’s APR rises, you may not see the new rate immediately, but you’ll eventually feel the impact if you continue to carry a balance.

Let’s say your card has an APR of 19 percent, your balance is $5,000 and you usually pay $150 toward your balance each month. Assuming you don’t continue to charge more on your card, it would take you four years to pay off the balance and you would pay $2,165 in interest.

Now, let’s say your APR has risen to 21.25 after a string of three-quarter-point hikes by the Fed. Your payoff timetable would increase to 51 months from 48 months and you would pay $2,626 in interest over that time period.

What can you do to lessen the impact of rising rates?

If you’re worried about your credit card’s rising rate, there are steps you can take to mitigate the impact:

Pay down your debt

If you are able to pay down the balance on your credit card, you can pay less interest on your remaining balance. For example, if your credit card has a balance of $5,000, your interest rate is 19 percent and you pay $150 per month,  you could save $926 and pay your debt off a year earlier by simply paying down your balance from $5,000 to $4,000.

Tip: Use CreditCards.com’s credit card debt payoff calculator to find out how much interest you’ll pay over time at your current interest rate and monthly payment.

Refinance or consolidate your debt

If you are currently carrying a high-interest credit card balance, you may be able to refinance your debt with a personal loan or home equity loan to take advantage of a lower interest rate.

Ask for a lower rate

Many cardholders are able to negotiate a lower rate with their credit card issuer by calling and asking for it. Note that your chances of success may be higher if your credit is in good standing.

Look for cards with better rates

Promotional interest rates are temporarily lower than the regular interest rate on a credit card account, and they are typically used as incentives to sign up for a card.

For example, a credit card issuer may offer a 0 percent APR on balance transfers for a certain time period — typically anywhere from six to 21 months. This gives you an opportunity to pay down debt more quickly, since your entire monthly payment is going toward the balance rather than interest charges. Just be aware that when the promotional period ends, the card’s regular APR will be assessed on the remaining balance.

If you don’t qualify for a 0 percent APR balance transfer offer, it may still be worth shopping for a card that has a lower APR than your existing card.

Improve your credit score

Your credit history affects the interest rate you pay on credit cards far more than any changes to market interest rates. A cardholder with a history of late payments and a low credit score may pay an interest rate two or three times as high as they would if they had an excellent credit score.

By working on your score,  you may soon be able to qualify for credit at lower rates. To improve your score, always pay your bills on time and keep your balances as low as possible. Avoid closing older credit card accounts and don’t apply for accounts you don’t absolutely need.

Consider nonprofit credit counseling

A nonprofit organization such as the National Foundation for Credit Counseling or American Consumer Credit Counseling can help you work out a debt management plan with your creditors. This can result in a lower interest rate and a reduced monthly payment. A debt management plan won’t hurt your credit score, but you may be required to close your credit card account.

Bottom line

Credit card interest rates will continue to rise as the Fed moves to tamp down inflation, with more rate hikes expected in 2023. If you’re carrying balances on your cards, take immediate steps to reduce the amount you’re paying in interest charges, such as consolidating your debt, asking for lower rates or signing up for new cards that can help you pay off your balances faster, with no interest.