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Federal Reserve policymakers this week announced a 50 basis points cut in the federal funds rate. The rate now sits at 1%, a five-year low. That's great news, right? The fact is, most consumers know little about what the federal funds rate is, and how it affects them. Here's a primer on what it means for you.
The Fed is charged with controlling monetary policy. One of the ways it controls the supply of money, and therefore factors like inflation and economic growth, is through manipulating interest rates by raising and lowering the federal funds rate.
The federal funds rate is the interest rate on money loaned between banks. Since banks must keep a certain percentage of their money in reserve, they must borrow money overnight from one another to make sure they have enough set aside. By lowering the funds rate, the Fed makes it cheaper for banks to borrow, which frees up more money that can be loaned to consumers.
When the federal funds rate rises, borrowing becomes more expensive and banks hold back more of their own money to cover the needed reserve. This leaves less money available to consumers and results in higher interest rates on everything from credit cards to car loans.
The federal funds rate is raised to fight inflation and lowered to stimulate the economy. How it affects your personal finances varies depending on the type of interest rate involved. Here's a list of different consumer rates and their likely changes due to the recent rate cut.
Interest rates on many credit cards are indexed to a bank's prime rate. When the Fed cuts rates, banks typically lower their prime rate, which is about 3 percentage points above the federal funds rate, by the same amount. If your credit card has an adjustable rate, it should go down with the rate cut. To check your interest rate, read the details section of your credit card agreement.
Credit card companies have been hit hard by consumer defaults and the sluggish economy, so many companies may limit the rate drop to less than the entire 50 basis points. If your bill next month doesn't show a drop in your variable rate, consider calling your credit card company to negotiate for a lower rate.
Car loans and home-equity loans are relatively short-term debts that tend to fluctuate with a lender's prime rate, which, in turn, moves along with the federal funds rate. Although an existing fixed-rate loan won't change with a drop in the federal funds rate, consumers shopping for a new loan stand to benefit from lower interest rates.
How much lower is a question of how worried banks are about their bottom line. The Federal Reserve may free up the cash supply, but banks still choose to pass on as little or as much of the benefits in the form of lower interest rates on loans. Shop around to make sure you get the best rates available, since not every lender will react the same way to the recent rate cut.
The federal funds rate has very little correlation to interest rates on 30-year fixed-rate mortgages, in part, because of the longer-term nature of the loan. (For more on this, read
.) Similar to fixed-rate mortgages, or FRMs, adjustable-rate mortgages, or ARMs, are only indirectly affected by changes in the federal funds rate. However, rates on ARMs do respond differently to market forces than FRMs, and changes in the funds rate can have a bigger impact on ARMs than FRMs.
Unfortunately, a drop in the federal funds rate usually leads to a decline in interest rates paid on savings accounts, money-market accounts and certificates of deposit, or CDs. When banks make less on the money they lend out, they offer less on the money you lend them. If you have a fixed interest rate on a CD, for example, the federal funds rate cut will have no effect. As with consumer loans, not all banks will change their rates by the same amount, so shop around to find the best deals.
Peter McDougall is a freelance writer who lives in Freeport, Maine, with his wife and their dog.