“I think we do need to try to not just rely on the central bank to, in its wisdom, adjust interest rates, but allow for people to avoid being exposed to inflation risk.”
Robert J. Schiller
The Fed has recently cut its benchmark fed funds by one quarter percentage for the second time in two months. This is the first time this has happened since the Great Recession of 2008-09. After keeping this rate at historically low levels, the Fed raised rates nine times beginning late 2015 through end of 2018 to 2.25-2.50%.
Leaving aside whether it was a good move (I believe it was, by the way), what does a lower fed fund rate (reduced 0.50% to now 1.75%-2.00%), mean for consumers in terms of borrowing, saving and investing?
Yes, The Fed Cut Is Beneficial For Consumers
A short answer is that a reduced fed funds rate means lower loan and savings rates. The fed funds rate is the lending rate for banks and other financial institutions. Declines will likely be relatively small unless we see future Fed cuts. If you have a lot of debt outstanding, you may feel more relief.
However, the best result in lowering monthly payments is to improve your credit score. You will see greater incremental benefits.
While we can’t borrow at the fed funds rate, it directly and quickly influences the prime rate, the loan rate charged to the best creditworthy customers. Prime rate was just lowered to 5.0% from 5.25%. Other consumer borrowing rates are often pegged to the prime rate, London Interbank Rate (LIBOR) or Treasury yields.
However, There Are Two Factors That Determine Your APR
The major consumer financial products are mortgage loans, home equity lines of credit (HELOCs), car loans, credit cards and student loans. Two factors are important lenders use to determine your loan’s annual percentage rate (APR). They are:
- Federal Reserve action to modify the federal funds rate, which is out of our control and
- Your credit score which you can take steps to raise for lower borrowing rates.
What About Savings And Investments?
The savings account rates at banks will likely decline quickly by 25 basis points (or one quarter of a percentage point) matching the fed’s lending rate for intra-bank loans overnight.
Our investments in financial securities, notably short and long term debt and equity securities tend to move in the opposite direction of interest rates.Therefore, the cut, which was anticipated by markets, usually improves performance upon widespread speculation. This cut may fuel beliefs of future cuts by the fed.
Lower borrowing rates often mean higher consumer and business spending and therefore stronger economic growth.
Before we take a look at how a Fed cut may influence consumer financial products, a little background on the Fed may be helpful.
A Short Primer On The Fed
The Fed (formally known as The Federal Reserve System) is the central bank of the US. They regulate commercial banks and have the responsibility for conducting monetary policy. Its dual goals are full or maximum employment and stable prices, meaning low inflation.
Through its monetary policy, the Fed uses its tools, notably the fed funds rate to influence money, credit, interest rates and the US economy overall. The fed funds is the rate at which banks and other financial institutions can lend to each other overnight to meet mandated reserve levels set by the Fed.
The Federal Open Market Committee (FOMC) votes on whether to raise, lower or keep the fed funds rate unchanged. FOMC members meet is at predetermined dates about eight times a year. It is made up of the seven Board of Governors of the Fed, notably Chairman Jerome Powell, plus the Presidents of five fed district banks (including the New York Fed).
For more on why you need to understand the Fed, read more here.
The Fed affects every aspect of our financial lives.
You should have a working knowledge of what does, particularly if you are interested in all aspects of money and investing.
The Fed, through its monetary policy, influences our economy, our borrowing and saving rates, as well as our investments. They have a powerful role in controlling money supply based on economic and inflation indicators, factors that affect our economy as well as global markets.
The Fed’s role is multifold:
- as the bank of last resort when other banks are unwilling to lend.
- assess risk in our economy based on numerous variables.
- a fiscal agent to the US Treasury supporting its securities auctions.
- model for other central banks globally.
- communicate publicly to explain their reasoning for their actions.
Mortgages: Fixed Rate or Adjustable Rates
The fed funds is a short-term rate but fixed rate mortgages are long term. When you borrow money to pay for your home purchase, you will likely choose between the conventional fixed rate mortgages or an adjustable rate mortgage (ARM).
Fixed rate mortgages are preferable for many home buyers. Your monthly payments are predictable for the length of your loan. Knowing your monthly amounts provides certainty and helps families to budget of one of the biggest costs.
Generally, 30 year mortgage rates are higher than the 15 year terms because of the longer time frame. Your rates will be highly influenced by your credit scores. Excellent scores of 750+ provide buyers with the lowest rates. I would encourage you to go for the shorter 15 year term as your total interest paid added to the home price is far lower.
Assuming you were applying for a 30 year loan, the average recent rate was 3.97% based on a range of 3.00%-7.84%. This range reflects best credit quality to fair (or riskier) borrowers. The 15 year average mortgage rate is 3.53% (on a range of 2.50%-8.75%).
Potential For Loan Refinancing
Those with the fixed rate mortgages will not be impacted by the Fed lowering the fed funds rate. However, if the Fed makes more rate cuts in the future, you may want to consider refinancing your mortgage if it makes financial sense for you. Refinancing costs additional fees. For potential buyers who have been on the fence in search for a new home, this cut could be an incentive.
Adjustable Rate Mortgages Will Benefit From Fed Rate Cut
Rates on adjustable rate mortgages (ARMs) change at different periods from annually, every 3,5, 7 or 10 years. They are reset based on either Treasury securities, inflation index or LIBOR. First time buyers often are attracted to ARMs as their initial rates are lower than the fixed mortgages.
A common ARM is 5/1, a hybrid mortgage, which is a 5 year fixed rate with annual rate changes after 5 years. A recent current average 5/1 ARM is 3.78% based on a range of 2.38-8.25% This may be attractive for someone expecting to sell their home or refinance to a fixed mortgage within 5 years. ARMs may fluctuate more quickly for those applying now, reflecting the Fed cut.
I have concerns with ARMs or any variable rate loans. They lack predictability and borrowers often don’t understand the terms of their agreements. Borrowers need to know when rates change and how they are impacted by rising interest rates. It is often difficult to budget their mortgage costs.
HELOCs Rates Will Decline If A Variable Loan
Most HELOCs are variable rate loans. This means that your month-to-month may fluctuate depending on the market interest rate. The benchmark is usually the prime rate. Some banks may offer a fixed rate option for customers who desire predictability and budget their costs. The typical fixed terms are 10 years and may range from 5-15 years.
Your HELOC loan is a credit line secured by the equity in your home and your creditworthiness. As your home serves as collateral like your mortgage, rates tend to be lower than credit cards. Once again, your credit score matters, along with Fed rate, which will determine your monthly payments.
How HELOCs Work
You may obtain an available line of credit of $100,000 but only draw $25,000 of the funds to pay your contractor. You will only pay interest on the $25,000. This provides benefits for your credit score based on your utilization rate which you can read about here.
Recent average 5 year fixed HELOC rates are 5.09% according to Value Penguin based on a wide range of 2.75%-11.00% to reflect excellent to fair credit ratings. Variable rate is 5.51% (with a range of 3.50%-13.25%). The latter are higher rates and may indicate greater risk.
Generally, you may obtain your HELOC with the lender you already have your mortgage loan with. It is a convenient way to tap the equity in your home to get available credit to borrow money for remodelling your kitchen. A small reduction in your variable HELOC may help you incrementally.
Car Loans Rate Will Change Based On Fed Rate Cut
Most car loan rates are based on fixed terms pegged to Treasury yields. The average loan rate on a 60 month for new cars according to the latest Federal Reserve Consumer Credit report. You are not likely to see any improvement on your existing loan rate or monthly payments. However, if you can refinance your car, you may recognize a difference in your monthly payments. On the other hand, your loan rate may vary based on three criteria.
1. New or Used Car
You will pay slightly more for a new car loan ( 4.30%) versus a loan for a used car (4.20%) or refinancing an existing loan (2.89%).
2. Credit Quality
As with all loans, your credit score matters. Your loan rate may range from excellent or 750+ (4.30%), good or 650-699 (7.65%) or fair to poor on 450-649 (13.23%). Monthly payments may skyrocket with fair or poor credit.
Assume the average price of a car of $36,000 and a 20% down payment of $7,200 on a 5 year loan. Using a car loan calculator, your monthly interest payment will jump from $$534 per month with excellent credit to $$659 per month with a poor credit rating.
Total interest paid over the life of this loan will be $3,258 with excellent credit or $10,721 in total interest paid. Your car price with excellent credit amounts to $39,258 versus $46,721 when your credit is poor. Interest costs are the second biggest part of your total car price and may account for 25% or more of your car cost).
3. Loan Term
Term length varies from 36 months to 96 months with the longer time frame requiring the borrow to pay the highest rate. You should get to a shorter term auto loan so you are not shelling out a lot of money on interest. Take the shortest loan term on cars that you can afford. That is a good strategy for any loans you apply for.
The length of the loans have been getting longer and longer. Edmunds says the most common term is for 72 months, with an 84 month loan next in line. I am seeing ads for loans for as much as 96 months. That is an increase from 10 years ago when 60 months were the most common.A longer time frame means you are paying more in total interest cost on your loan.
What You Can Do About Lower Monthly Payments (Or No Payments At All)
Future car buyers may get reduced rates based on the latest Fed cut. However, your best path to a lower auto loan is to improve your credit score. Better yet, buy a used car outright without a loan. After years of car loans and leases (watch for hidden fees!), we are finally biting the bullet and buying older cars with more mileage for cash. Getting rid of these monthly payments are a longer term relief.
Credit Cards Rates Are Likely To Decline
Credit cards carry the highest borrowing rates of most consumer loan products. Their rates are linked to the prime rate which is quickly influenced by the Fed’s benchmark rate. Interest rates will likely go down as a result of the lower prime rate. Of course, those high rates may not be a problem at all if you pay your card balances in full every month.
Unfortunately, the average credit card debt was $8,398 in June 2019. While the recent Fed reduction may trim some basis points off your APR, lenders are not required to lower rates when the Fed does so. However, there is a lot of competition for borrowers. If credit card issuers do, it will be marginal on on new cards. Lenders are far more willing to increase APRs when the Fed raises the fed funds rate.
Once again, issuers mostly look to your credit score for assessing your risk as a borrower. At the end of 2018, the average credit card rate for new offers were 19.24% and 14.14% for existing offers. The range for those with excellent scores were 14.41% to fair scores at 22.57%. The national average rate did drop to 17.61% recently after factoring in the 50 basis point decline in the fed funds rate in 2019.
Good News For Student Loans
There is some good news on federal loans for undergraduate and graduate students and their parents for the 2019-2020 school year. This is the first time that these rates have dropped in three years. The rates for these loans were tied to the May 2019 Treasury auction for 10 year notes. Student loans have been a front page burning issue, likely to ramp up alongside the upcoming Presidential election debates.
Federal loans are fixed only with 10 year loans for school years as follows:
Type 2019-2020 2018-2019
Direct Subsidized (student) 4.53% 5.05%
Direct Unsubsidized (student) 4.53% 5.05%
Direct Parent Plus 7.08% 7.60%
Graduates Unsubsidized 6.08% 6.60%
There is a cap on the amount you may borrow from the federal government for student loans. Undergrads may borrow up to $12,500 annually and $57,500 in total for student loans from federal sources. Graduates are capped at $20,500 yearly and $138,500 in total.
You need to consult the Federal Student Aid guide as the amount you may borrow depends on what year you are going into at school and your dependency status. These loans are not dependent on your credit score. For more on how to pay for college, see our family guide.
Due to federal loans being capped, most students will turn to private lenders where the credit scores of the students and parents matter. Loans may be fixed and potentially go for terms of 10-20 years or are variable. It is a good idea to pay back your student loans faster if at all possible.
The variable rates are influenced by changes in the prime or LIBOR plus the fixed margin tied to your credit score for your total rate. LIBOR rates tend to increase less slowly than the prime rate.
Banks may require a minimum credit score of 600-650 or better. So it is best to work on improving your credit report before borrowing. 24% of families in 2019 borrowed money from federal loans, private student loans, credit cards and other loans. 7% of students and parents each used their credit cards, loans from retirement accounts or other sources.
Savings And Investing
Savings accounts at banks, including online banks, are likely immediately vulnerable to reduced rates after the latest cut in the fed funds rate. These rates have been low for years and not much of a source of interest income for savers as they have been in the past. However, these accounts did perk up after the rate increases in late 2018 enough to merit ads with “high yield savings rates.”
September 2019 rates have dropped in mid September after the August rate cut but likely not fully reflected. Average savings rates range from 2.00%-2.50%, with many banks requiring minimum amounts of $100-$10,000. Please read the fine print as there may be fees.
Savings accounts are great for accessibility to liquid funds such as your emergency money. Money market funds may offer slightly higher rates than saving accounts. They are great alternatives for safety and liquidity purposes. If the Fed continues to reduce rates, expect more trimming ahead. I don’t wish for high inflation but there was a time (1980-1982) that these accounts provided double digit returns with virtually no risk.
The Bull Case For Investing When Interest Rates Go Lower
Generally, when interest rates go lower, consumers and corporate borrowing increases. The lower interest rates may help some segments of our economy, like industrial companies. They have not participated in higher growth as much. Lower rates often results in strong economic growth. With low savings rates at 2.5% or lower, consumers have less incentive to leave money in the bank earning low returns.
Households may spend more by borrowing for a home or car. The reduction we saw in August and in September may be a small incentive for more buying of consumer assets.
Remember we have had a low interest rate environment with already low mortgages and HELOC rates. The housing and car markets have been strong in recent years because of lower borrowing rates. Those who may have wanted a house or car may already have done so. Can another 25 basis point encourage more buyers to look for new buyers? Maybe. Consumer spending has remained fairly strong particularly in the retail markets.
Better Long Term Returns From Stock Investing
I avidly participate in the stock market which are at or close to all-time highs. When the Fed reduces the fed funds rates, financial securities usually respond favorably or even upon speculation of an upcoming cut. Expectations of a stronger economy tend to push stocks higher. There are always risks that the market rotates from one issue to the next or one sector of stocks or another. To reduce risk, make sure to diversify your portfolio.
For example, US-China trade talks (on or off). There are some pockets of weakness being experienced in different sectors such as industrial companies such as Caterpillar, Fedex, and companies more dependent on strong global markets.
Households may seek higher returns from stocks which grow 8% annually over the longer term. Alternatively, they may seek higher yielding stocks such as ATT, Verizon or BP than they can earn in their savings banks.
Better yet, I would recommend those interested in stocks, to buy a low cost index fund. Vanguard funds are known for their low cost and choices in funds that focus on growth, value, blend or want something to mirror the market like S& P 500. Investors can also look at target rate funds.
The rate cut from the Fed was a welcomed event though it will likely have only marginal benefits for the average consumer. With lower interest rates it is cheaper to borrow than save. This usually leads to increases in spending. That is good for economic growth.
Still, households would realize even better financial health by improving their credit scores, reducing debt and spending within their means. This should be a priority so that you can invest more. Savings are great for liquidity but careful investing could provide better returns.
Have you noticed any reductions in your loan rates? Have the lower rates increased your consideration for house or car hunting? We would like to hear from you about your thoughts and experiences!
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.