“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 Federal Reserve cut its benchmark fed funds to 0.0%-0.25% in March 2020, where it remains today. This is only the second time the Fed has kept this rate close to zero since 2008-09.
The Fed uses this essential tool to stimulate the economy when we are going into a downturn, resulting from the pandemic and lockdowns. The Fed’s next potential move may be to slowly raise the fed funds rate to combat inflation above its 2% target.
How does the Fed affect loan rates and what does it mean for consumers in terms of borrowing, saving, and investing?
Yes, A Lower Fed Funds Rate Is Usually Beneficial For Consumers
A reduced fed funds rate means lower loan and savings rates, so consumers spend more. The fed funds rate is the lending rate for banks and other financial institutions. 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, and you will see more significant incremental benefits.
While we can’t borrow at the fed funds rate, it directly and quickly influences most other interest rates such as the prime rate, the loan rate charged to the best creditworthy customers. Different consumer borrowing rates are often pegged to the prime rate, London Interbank Rate (LIBOR), or Treasury yields.
However, Two Factors Determine Your APR
The primary consumer financial products are mortgage loans, home equity lines of credit (HELOCs), car loans, credit cards, and student loans. Two essential factors: 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 current markets will start to reflect increases to near-zero fed funds rates. If the next move is a rise in fed funds rates, that may cause market volatility.
Lower borrowing rates often mean higher consumer and business spending and, therefore, more robust economic growth. Higher borrowing rates do the opposite, and consumers will slow their spending and increase savings because of higher yields at the bank.
Before we 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.
The Fed uses its tools, notably the fed funds rate, to influence money, credit, interest rates, and the overall US economy through its monetary policy. The fed funds are 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 raising, lowering, or keeping the fed funds rate unchanged. FOMC members meet at predetermined dates about eight times a year. The voting members of the FOMC are 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 the Fed does, mainly 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 an influential role in controlling money supply based on economic and inflation indicators, factors that affect our economy and 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 and supports 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 are 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 conventional fixed-rate mortgages or an adjustable-rate mortgage (ARM). Conventional mortgages are more common. The Fed does set mortgage rates, but their actions may influence the direction of the rates.
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 one of the highest costs.
Generally, 30-year mortgage rates are higher than the 15-year terms because of the longer time frame. Your credit scores will highly influence your rates, and a score of 750+ provides 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 rate was 3.01%, according to NerdWallet. This range reflects the best credit quality to fair (or riskier) borrowers. The 15-year average mortgage rate is 2.254%
Potential For Loan Refinancing
Those with 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. When the fed dropped their rates to their lowest levels in 2020, there was significant mortgage loan refinancing, or it encouraged potential buyers who have been on the fence searching for a new home.
HELOCs Rates Are Variable Loans
Most HELOCs are variable-rate loans. That 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. Fixed terms are ten 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 the 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.
Generally, you may obtain your HELOC from your existing mortgage lender. It is a convenient way to tap the equity in your home to get available credit to borrow money for remodeling your kitchen. A slight reduction in your variable HELOC may help you incrementally.
Car Loans Rate Will Change With Fed Action
Most car loan rates are based on fixed terms pegged to Treasury yields. The average loan rate is 3.74% or higher on a 72-month loan for new cars depending on your credit score. You are not likely to see any improvement in your existing loan rate or monthly payments. However, if you can refinance your car, you may recognize a slight 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 versus a loan for a used car or refinancing an existing loan.
2. Credit Quality
As with all loans, your credit score matters. Your loan rate may range from excellent or 750+ , good or 650-699, or fair to poor on 450-649. Monthly payments may skyrocket with fair or poor credit.
3. Loan Term
Term length varies from 36 months to 96 months with the longer time frame requiring you 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 has 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 Go Down With Lower Fed Rates
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 Fed rate reduction trims 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 new cards. Lenders are far more willing to increase APRs when the Fed raises the fed funds rate.
Good News For Student Loans
There was 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 Treasury auction for 10-year notes. These rates are still in force along with the Fed rates remaining near zero.
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.”
According to the FDIC, the national average interest rate on savings accounts are 0.06 APY from the brick and mortar banks while online banks offer higher savings accounts starting in the 0.40%-0.50% range. Please read the fine print as there may be fees and minimums.
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 keep rates low as they are now, expect low savings rates. I don’t wish for high inflation but there was a time (1980-1982) that these and money market accounts provided double-digit returns with virtually no risk.
The Bull Case For Investing With Low Interest Rates
Generally, when interest rates go lower, consumers and corporate borrowing increase. The lower interest rates may help some segments of our economy, like industrial companies that have high capital budgets. The
Households may spend more by borrowing when rates are low. However, we are seeing inflation creep upwards to 6.2% from the latest CPI report, and feeling higher prices for groceries and at the pump. High inflation cuts our purchasing power and will likely reduce our spending, pushing the Fed to potentially change its monetary policy
Better Long Term Returns From Stock Investing
I avidly participate in the stock market which is at or close to all-time highs. When the Fed reduces the fed funds and keeps rates low, financial securities usually respond favorably 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.
Households may seek higher returns from stocks that grow 10% annually over the longer term. Alternatively, they may seek higher-yielding stocks such as ATT or Verizon than they can earn in their savings banks.The recent high inflation has turned heads to look at Series I savings bonds at 7.12% or TIPs, Treasury bonds that adjust monthly with inflation.
I would recommend those interested in stocks, 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.