6 ways the Fed’s interest rate decisions impact you

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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, mostly to analyze what’s happening with employment and inflation.

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.”

But deciding what to do with interest rates isn’t always easy. Even if you’ve only been loosely following the Fed, you’ll know that U.S. central bankers have had a hard time determining when to cut off the world’s largest economy from stimulus.

Officials in early 2021 said they would keep borrowing rates at record lows to give millions of sidelined workers more time to find a new job, even in the face of higher inflation. But as the months went by, joblessness sank, fewer workers jumped back into the labor force and inflation kept boiling — eventually reaching a 40-year high. At the start of 2022, officials are now abandoning that patient stance, preparing to hike interest rates at least three times this year.

Here are six ways that you can expect the Fed to impact your wallet.

1. The Fed affects credit card rates

Most credit cards charge a variable interest rate based on the prime rate, which is linked to the Fed’s key benchmark policy tool: the federal funds rate.

Historically, the prime rate has held 3 percentage points above the Fed’s rate, rising and falling along with each move out of the U.S. central bank.

“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, senior vice president and chief economist at PNC Financial Services Group.

Credit card rates, however, will never be as low as the Fed’s benchmark. That’s because companies charge the prime rate plus another margin that they determine themselves, often based on the strength of their customers’ credit scores. As of Jan. 19, the average credit card annual percentage rate (APR) is 16.30 percent, according to Bankrate data.

That could climb even higher when the Fed starts to make borrowing more expensive, with McBride forecasting that the average APR will rise to 16.9 percent by year end.

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 when rates go up. Savers benefit from rate hikes and take a hit when the Fed decides to cut them.

That’s because banks typically lower the annual percentage yields (APYs) that they offer on their consumer products — such as high-yield 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.

Even with interest rates at historic lows, consumers can still find CDs and savings accounts on the market offering yields well above the national average if they shop around.

Another rate also matters for the cash that you have stashed away: inflation. Individuals should look at the inflation-adjusted rate of return, particularly with 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.

Today’s high levels of inflation coupled with rock-bottom rates mean it’s another component worth thinking about before deciding to lock away your money.

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.

Mortgage rates may even rise absent any Fed moves. That’s been especially evident at the start of 2022, when mortgage rates jumped to pre-pandemic highs as inflation soars and the expectation that the Fed will raise rates this year grows.

The Fed, however, can more directly influence interest rates by buying bonds and mortgage-backed securities, an unconventional form of rate-setting that pushes down longer-term debt costs.

And even though the Fed has little direct control over mortgage rates, both end up being influenced by similar market forces, McBride says. Mortgage rates, for example, fell to historic lows as the economy felt the impact of the coronavirus pandemic.

And keep in mind that consumers with a fixed-rate mortgage likely won’t feel any impact from the Fed’s rate moves. That’s because their interest rate is set for the entire life of the loan. That’s unless they decide to refinance, which could be a smart option for your pocketbook if it means securing an even lower rate than when you first took out your home loan.

“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 Jan. 19, the average rate on a $30K HELOC is 4.11 percent, according to Bankrate data. The average rate was 4.02 percent just last April.

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 3.93 percent as of Jan. 19, down from 4.15 percent last September, according to Bankrate data.

6. The Fed can impact your investment returns

Cheap borrowing rates often bode well for investments because they incentivize risk-taking among investors trying to compensate for lackluster returns from bonds, fixed income and CDs.

On the other hand, markets have been known to choke on the prospect of higher rates. Part of that is by design: Essentially, the U.S. central bank zaps liquidity from the markets when it raises rates, leading to volatility as investors reshuffle their portfolios.

It’s also because of worries: When rates rise, market participants often become concerned that the Fed could get too aggressive, slowing down growth too much and perhaps tipping the economy into a recession. That’s at least been evident by the bumpy start to 2022, with the S&P 500 down nearly 8.5 percent from its January high and near correction territory.

For those reasons, it’s important to keep a long-term mindset and avoid making any knee-jerk reactions. When the Fed raises rates, that’s mostly to make sure the financial system doesn’t derail itself by growing too fast.

“Low rates are like candy to investors and keeping rates low is like asking the Cookie Monster if there should be more cookies,” McBride says. “Mom-and-pop investors should focus on the bigger picture: An economy that’s growing is conducive to an environment where companies will grow their earnings, and ultimately, a growing economy and higher corporate earnings are good for stock prices. It just might not be a smooth road between here and there.”

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,” he says. “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.

Interest rates should also never discourage you from building an emergency savings cushion, which 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.

On the flipside, paying off high-cost debt 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.

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