How Lower Fed Funds Rate Affects Personal Loans
The federal government regulates interest rates, making it more or less attractive for banks to borrow money from each other. This activity also affects you, costing you more (or less) in interest charges on select loans and credit cards.
Have you ever noticed how credit cards often state that their interest rates are variable? Or how your mortgage broker encouraged you to “lock in” your mortgage’s interest rate before it changed? The entity behind these fluctuations in interest rates is the Federal Reserve, the nation’s central bank, responsible for the state of the U.S. economy.
Commonly called the Fed, the institution monitors and keeps financial activity balanced. Although the United States operates as a free market, the Fed has the power to make necessary changes to protect the economy from inflation, unemployment or a financial crash. And one of the most effective ways the Fed keeps the economy running in tip-top shape is by adjusting the rates at which banks can borrow money from each other.
What are Fed’s funds rates?
The federal funds rate is the cost at which banks borrow money from each other. The Fed can control the flow of money by raising or lowering the rate to stabilize the economy. The Fed typically meets eight times per year to review economic activity and adjust the rate, unless there’s a reason to meet more often, such as during the coronavirus crisis.
Banks closely follow the committee’s meetings since their borrowing activity can be affected by any changes to the fed funds rate. You may not have noticed, but banks borrow money from each other all the time. The interbank loans are typically short-term (usually overnight). Banks will borrow from each other to meet the Federal Reserve’s rules on the amount of cash a bank should have available in reserves to cover customer withdrawals.
Banks review their reserve levels at the end of each business day. If a bank has less than required in reserves, it can borrow money from other banks who may have closed out the day with more cash than needed. Banks can make money lending out their cash surpluses this way. The average fed funds rate in 2019 was 2.16% and 1.11% in 2020. It may not sound like much, but lending out millions of dollars every day can make a bank some significant cash.
Why does the Fed change interest rates?
As mentioned, the Fed may discover during one of its annual meetings that inflation is creeping up or employment is dropping, warning of an economic slowdown. The economy may need a boost — and lowering or raising the federal funds rate can help.
When the Fed drops the rate, money access is cheaper — and banks will pass on the savings to customers like you, charging lower interest rates on credit cards, variable-rate home loans and lines of credit. Not all personal loans are affected by fed rate changes. Most installment loans and mortgages have a set interest rate for the duration of the loan, even if the fed fund rate drops or rises. Only variable-rate loans and credit products may see a change in interest rate costs from one month to another.
The Fed recently made two emergency fed fund rate cuts due to economic concerns related to the COVID-19 outbreak. It cut the central bank’s overnight lending rate by half a percentage point. The Fed wants to encourage banks to make affordable loans between each other, as well as to businesses and individuals down the road.
There are occasions when the Fed may want to raise (instead of drop) the interest rate. Why would they if banks are borrowing and consumers are snatching up affordable loans to buy cars, homes and other goods? There are a couple of reasons why.
The Fed may want to raise the cost for banks borrowing money when things are going very well as a backup plan should the economy experience a downturn. Imagine this — the economy is growing, people are spending money and taking out loans because borrowing is cheap due to low fed fund rates. But if the economy experiences a downturn and the interest rate is already low, the Fed won’t be able to drop it much more to stimulate economic activity.
Another reason the Fed may want to raise interest rates is because of inflation. Inflation makes everything more expensive because the value of money is reduced — you won’t be able to buy as much with your money as you used to. Raising interest rates higher than inflation offsets the problem by adding more value to your money. You may not want to borrow as much, but the interest rate increase is good for your savings, helping you earn more on the cash you have parked in a savings account.
How do lower Fed rates affect personal loans?
The recent drops by the Fed due to the coronavirus outbreak are historic. The last time the Fed aggressively reduced rates was during the 2008 Great Recession. The move may go down in the history books, but you’re not likely to see a big change in the short term. If you currently have a home mortgage or other type of traditional loan, your interest rate or monthly payment won’t change.
However, even though the Fed lowered mortgage rates and interest rates for savings accounts, there won’t be much change seen for personal loans. Even though the banks are borrowing short-term money from one another at lower rates, those lower rates aren’t passed on in personal loans – it will only truly affect student loans, mortgages, certificates of deposit and other savings accounts.
This doesn’t mean it’s not a good time to borrow. Especially if you’re in an emergency situation during this drop in the economy, a personal loan can bridge the financial gap you’re experiencing between what you need and what you have. It’s important to shop around different lenders to find the best rate and to make sure you borrow only what you need.