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Credit cards are one of the most expensive ways to borrow money because interest rates are very high.
Still, at least one-third of credit card users carry a monthly balance, according to the Boston Fed.
But a new paper published by the Boston Fed finds that when credit card interest rates change, cardholders adjust their spending accordingly.
On average, a 1 percentage point increase in your credit card’s annual percentage rate (APR) will reduce your credit card spending by about 9% in the next month. This is an “economically meaningful response,” the researchers found.
When borrowing becomes more expensive and consumers pay less on their cards, their debt burden also decreases, the report found.
“When interest rates go up, it seems like a lot of people are going to spend as little as possible,” said Ted Rothman, senior industry analyst at Bankrate.
“We see a similar phenomenon with petrol prices. There is evidence that recent price increases have led many people to drive less and combine trips where possible,” he said. “Consumer spending may therefore be more reasonable than many people think.”
How the Fed affects credit card interest rates
Credit card interest rates are generally pegged strictly to the prime rate, which is the interest rate that banks charge their most credit-worthy customers. It is typically 3 percentage points higher than the federal funds rate, which is set by the Federal Reserve System’s Federal Open Market Committee.
When the Fed raises or lowers interest rates, the prime rate changes as well, and interest rates on credit card debt can follow within a billing cycle or two.
After the Fed raised rates in 2022 and 2023, average interest rates on credit cards rose from just over 16% to over 20%, reaching a record high in 2024. Since then, annual interest rates have declined slightly to an average of about 19.58%, according to Bankrate.
Matt Schultz, chief credit analyst at LendingTree, said that despite some reports indicating that cardholders who carry balances are not aware of the interest rates they are being charged, “this data shows that people who carry balances are acutely aware of credit card interest rates and adjust their behavior, at least to some degree, when interest rates change.” “That’s good.”
According to the Federal Reserve Bank of Boston, a 9% decrease in spending due to a 1-point increase in APR reduces your credit card bill by about $74 per month. However, these changes will not occur across the board.
“Financially constrained consumers…are the most sensitive,” said Falk Browning, an economist at the Boston Fed and a co-author of the report.
For those with balances, a one-point increase in annual interest rates can reduce spending by up to 15% the next month, Browning said, largely because these borrowers are likely to have less financial resources and limited access to alternative forms of credit. “Whether or not you can own a revolver has a lot to do with your economic status.”
Alternatively, a Boston Fed study found that people who pay off their balances in full at the end of the month are less sensitive to changes in interest rates. “This result is intuitive: higher interest rates do not directly increase purchase costs if you are not paying interest,” the report said.
“There’s also a strong sense of a K-shaped economy here, where high-income households are driving the economy forward while low- and middle-income households are shrinking the economy,” Rothman said.
Fed’s next move
Since December, the federal funds rate has remained stable within its target range of 3.5% to 3.75%, and credit card rates have also remained largely unchanged. Futures market pricing suggests there is little chance of a rate cut at the next meeting in April, according to CME Group FedWatch indicators. In fact, the central bank is largely expected to keep policy unchanged through the first half of this year.
At the same time, rising energy costs and growing concerns about stagflation have led to widespread market belief that the Fed’s next move may be to raise rates.
Just Friday morning, futures market traders raised the possibility of a rate hike by the end of 2026, according to CME Group’s FedWatch tool.
Fed Chair Jerome Powell said on Monday that the central bank doesn’t need to raise rates yet because “inflation expectations do appear to be firmly anchored.”
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