5 ways the Fed’s interest rate decisions impact you

6 min read
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The Federal Reserve on Sunday made its second emergency rate cut in response to economic concerns related to the coronavirus, opting to slash rates to a range of 0-0.25 percent.

The central bank of the U.S. – also known as the Fed – is charged by Congress with maintaining economic and financial stability. Mainly, it tries to keep the economy afloat by raising or lowering the cost of borrowing money, and its actions have a great deal of influence on your wallet.

Officials on the Fed’s rate-setting Federal Open Market Committee (FOMC) typically meet eight times a year. The Fed looks at a broad range of economic indicators, but most notably, it pays attention to employment and inflation data. The Fed was scheduled to have its next meeting this week on March 17-18. The meeting will no longer happen coming off the Fed’s emergency cut.

Why does the Fed raise or lower interest rates?

The logic goes like this: When the economy slows – or merely even looks like it could – the Fed may choose to lower interest rates. This action incentivizes businesses to invest and hire more, and it encourages consumers to spend more freely, helping to propel growth. On the contrary, when the economy looks like it may be growing too fast, the Fed may decide to hike rates, causing employers and consumers to tap the brakes on their financial decisions.

“When the Fed raises or reduces the cost of money, it affects interest rates across the board,” says Greg McBride, CFA, Bankrate chief financial analyst. “One way or another, it’s going to impact savers and borrowers.”

Even if you’ve only been tangentially following the Fed, you’ve probably noticed that it’s been a bumpy past few months. Officials cut interest rates three times in 2019, months after signaling to investors that they’d intended to hike at least two more times. U.S. central bankers now say they’re comfortable with waiting on the sidelines over the next 12 months, as they wait for evidence on just how much the three reductions impacted the economy.

Still, policy isn’t set in stone, and there’s a lot that could happen over the next year that might yank the Fed in a different direction. Here are five ways that you can expect the Fed to impact your wallet.

1. The Fed affects credit card rates

Most credit cards have variable interest rates, and they’re tied to the prime rate, or the rate that banks charge to their preferred customers with good credit. But the prime rate is based off of the Fed’s key benchmark policy tool: the federal funds rate.

In other words, when the Fed lowers or raises its benchmark interest rate, the prime rate typically falls or rises with it.

“What the Federal Reserve does normally affects short-term interest rates, so that affects the rates that people pay on credit cards,” says Gus Faucher, chief economist at PNC Financial Services Group.

Leading up to the July rate cut, the prime rate was 5.50 percent, 3 percentage points higher than the top end of the fed funds rate’s target range of between 2.25 percent and 2.5 percent. It typically stays at that level — even as the Fed cuts rates.

By December, after the Fed’s three cuts were already enacted, the prime rate had fallen by 75 basis points. That’s how much the Fed reduced rates in total.

But credit card borrowers will be hard pressed to find an interest rate that’s actually that low. After the Fed’s three cuts, average credit card rates only fell slightly, to 17.36 percent from 17.8 percent, according to Bankrate data that tracked rate changes between Sept. 4 and Dec. 18. In reality, credit card rates are much higher because companies charge the prime rate plus another margin that they determine themselves.

2. The Fed affects savings and CD rates

If you’re a saver, you’ll likely have the opposite reaction of a credit card borrower. Savers benefit from rate hikes and take a hit when the Fed decides to cut them.

That’s because banks typically choose to lower the annual percentage yields (APYs) that they offer on their consumer products — such as savings accounts — when the Fed cuts interest rates. For example, banks in June 2019 lowered their yields in anticipation of a rate cut.

But when and by how much banks choose to lower yields after a rate cut depends on those broader conditions, as well as competition in the space, McBride says. It’s also worth remembering that most high-yield savings accounts on the market have annual returns that outpace inflation.

“If the Fed cuts rates, yields will fall, but you’re still going to be far ahead from where you were a few years ago,” McBride says. “Even if they unwind one of the nine rate hikes that they’ve made since 2015, the top-yielding accounts are still going to be paying a rate above inflation.”

Yields on certificates of deposit (CD) generally fall when the Fed cuts rates as well, but broader macroeconomic conditions also have an influence on them, such as the 10-year Treasury yield.

But individuals should focus on the inflation-adjusted rate of return on CDs, says Casey Mervine, vice president and a senior financial consultant at Charles Schwab. In the late 1970s, for instance, yields on CDs were in the double digits; inflation, however, was as well. That means consumers’ actual earnings were much lower, due to the erosion of their purchasing power.

If you’re worried about a Fed rate cut impacting your returns, consider locking down a CD now.

“Sometimes people start lowering their rates in anticipation of a cut,” says Katie Miller, senior vice president of savings products at Navy Federal Credit Union. “That’s why I say, if you see some good CD rates, take them.”

3. The Fed’s influence over mortgage rates is complicated

Mortgage rates aren’t likely going to respond quickly to a Fed rate adjustment. Interest rates on home loans are more closely tied to the 10-year Treasury yield, which serves as a benchmark to the 30-year fixed mortgage rate.

That’s evident when you look into the past. Each time the Fed has adjusted rates, mortgage rates haven’t always responded in parallel. For example, the Fed hiked rates four times in 2018, but mortgage rates continued to edge downward in late December.

But even though the Fed has little direct control over mortgage rates, both end up being influenced by similar market forces, McBride says.

“While not directly related to a Fed cut, the two are sort of a reflection of the same concern: the expectation that the economy is going to slow,” McBride says.

Right now, that’s been the fear about both the domestic and global economy. U.S. hiring slowed in 2019, while manufacturing is outright contracting. Growth around the world is also decelerating, and it’s prompting many other central banks around the world to start cutting rates as well.

It’s highly likely that you’ll start to see those long-term rates slip lower in tandem with short-term borrowing costs, Miller says.

“It’s long-term expectations that tend to dictate where mortgage rates go more than short-term, but even long-term expectations are getting a little bit lower here,” according to Miller. “You’ll probably see mortgage rates come down as well. The more that comes down, the better off you are, especially if you’ve gotten you a mortgage in the last couple of years.”

That means refinancing could be a smart option for your pocketbook. A reduction in even just a quarter of a percentage point could potentially shave off a couple hundred dollars from your monthly payments.

“Mortgage debt tends not to be high cost; it’s just high interest because of the value of the actual mortgage itself,” Miller says, “which is why small changes in rates can make a big difference.”

4. The Fed impacts HELOCs

However, if you have a mortgage with a variable rate or a home equity line of credit – also known as a HELOC – you’ll feel more influence from the Fed. Interest rates on HELOCs are often pegged to the prime rate, meaning those rates will fall if the Fed does indeed lower borrowing costs.

Modest Fed moves, however, likely aren’t going to steer those rates in a drastic direction either, McBride says.

5. The Fed drives auto loan rates

If you’re thinking about buying a car, you might see slight relief on your auto loan rate. Even though the fed funds rate is a short-term rate, auto loans are still often tied to the prime rate.

It might, however, be a modest impact. The average rate on a five-year new car loan is 4.56 percent, down from 4.72 before the Fed cut rates in July, according to Bankrate data.

Bottom line

When the Fed cuts rates, it’s easy to think of it as discouraging savings, McBride says. “It’s reducing the price of money. It incentivizes borrowing and dis-incentivizes savings. Essentially, it gets money out of bank accounts and into the economy.”

On the other hand, a Fed rate hike discourages borrowing, as the cost of money is now more expensive.

But that doesn’t mean it’s a bad time to save. Building an emergency savings cushion, and saving in general, is a prudent financial step.

“Good savings habits are important independent of the interest-rate environment,” Miller says. “Your transmission in your car, if it breaks, it doesn’t realize if rates are low.”

Stay ahead of any Fed rate moves by keeping an eye on your bank’s APY. Regularly checking your bank statement can also help you determine whether you’re earning a rate that’s competitive with other options on the market.

If the Fed looks like it’s going to hike rates, paying off high-cost debt ahead of time could create some breathing room in your budget before a Fed rate hike. Use Bankrate’s tools to find the best auto loan or mortgage for you.