It’s one of the most complex institutions in the world, yet it has perhaps the biggest influence over your wallet.
The central bank of the U.S. – also known as the Federal Reserve – is charged by Congress with maintaining economic and financial stability. The institution is best known for keeping the economy afloat by raising or lowering the cost of borrowing money.
Officials on the Fed’s rate-setting Federal Open Market Committee (FOMC) are tasked with making those decisions, typically at eight meetings a year. The Fed looks at a broad range of economic indicators, but most notably, it pays attention to employment and inflation data.
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 crafting monetary policy is a delicate balancing act. Officials cut interest rates three times in 2019, months after signaling to investors that they’d intended to hike at least two more times. The Fed then made two emergency rate cuts in March 2020, slashing rates to a target range of 0-0.25 percent to help cushion the economy from the impact of the coronavirus pandemic.
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 2019 rate cut, the prime rate was 5.5 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. The prime rate is now at 3.25 percent after the Fed cut rates to near-zero.
But credit card borrowers will be hard pressed to find an interest rate that’s actually that low. In reality, credit card rates are much higher because companies charge the prime rate plus another margin that they determine themselves. Still, the average APR on variable credit cards has been on the decline. As of April 21, the average credit card APR is 15.98 percent, according to Bankrate data.
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.
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.
With CDs, individuals should focus on the inflation-adjusted rate of return, 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 falling yields impacting your returns, consider locking in a CD now.
3. The Fed’s influence over mortgage rates is complicated
Mortgage rates are not tied to the Fed’s interest rate decisions. 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. Mortgage rates have fallen to historic lows as the economy feels the impact of the coronavirus pandemic.
“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.
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, which is why small changes in rates can make a big difference,” says Katie Miller, senior vice president of savings products at Navy Federal Credit Union.
4. The Fed impacts HELOCs
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.
Average HELOC rates have fallen sharply since the beginning of the year. As of April 21, the average rate on a $30K HELOC is 4.02 percent, according to Bankrate data. The average rate was 6.15 percent at the start of 2020.
5. The Fed drives auto loan rates
If you’re thinking about buying a car, you might see some 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.
The average rate on a five-year new car loan is 4.15 percent as of April 21, down from 4.6 percent to start the year, according to Bankrate data.
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 disincentivizes 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.
Whenever the time comes for the Fed to start increasing 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.