The Fed Cuts Rates – What Does That Mean For Me?

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Whenever the Federal Reserve makes a move, it dominates headlines. I watched CNN for a while yesterday while waiting for a meeting and they kept going back to the big news that the Federal Reserve cut the prime lending rate by 0.75%. Most news stories make it clear that this is theoretically beneficial to stocks, and it did prevent a stock market collapse, turning a potentially terrible day on the stock market into just a mildly bad one.

However, for most people the actions of the Federal Reserve seem to have no connection to their day to day life. The prime lending rate? What does that have to do with my day to day life?

First of all, the prime lending rate is the interest rate that banks charge each other for short term loans. If a bank needs some quick cash, it can always borrow it from a bank down the road for that prime lending rate. Thus, most banks use this rate as the baseline for the interest rates they can give on savings accounts (they should be less than the prime rate, or at least close to it) and also on the interest rates they can give on loans (these should be above the prime rate, but competition keeps them low).

Thus, many, many other rates that do affect your life are affected by the prime lending rate. Let’s look at them.

The interest rates on your savings accounts will drop. Your local bank probably won’t change much – they offer so little on the average savings account that it doesn’t matter too much. However, over the next few weeks, a lot of online savings accounts will adjust downwards – probably something close to 0.75% in their savings rate. Some banks will change faster than others, so the next month is a bad time to do any rate jumping. Just stick with where you’re at, know that rates will go down, and wait it out for a bit.

The interest rates on mortgages will drop, perhaps convincing you to refinance. If you were looking at buying a house with a nice, stable thirty year fixed mortgage, this is amazing news because your mortgage rate will drop around 0.75%. On a $200,000 thirty year loan, Ben Bernanke just saved you $71 a month for the next thirty years – a total of $25,635.

That’s a lot of cash, and people out there with a fixed rate mortgage might be interested in refinancing if they can save $15,000 over the life of their loan. It might cost $3,000 or so to refinance, but if the total savings is $12,000 over the loan’s life, that’s plenty of incentive for most people. Incidentally, this will drive a lot of cash into the coffers of mortgage lenders, which will help with the subprime mess.

The interest rates on car loans will drop. This means that if you buy a car in the next few months, the payments will be substantially lower than they would have been without this drop. Since I’m personally thinking about purchasing a van in the early summer, this is good news for me.

The interest rates on variable rate credit cards will drop. Most credit cards have their rate fixed at the prime rate plus some specific percentage – prime plus 11.9%, for example. Since the prime rate just dropped by 0.75%, many credit card rates just dropped 0.75%, which will help a bit if you have a large credit card balance.

In a nutshell, when the Federal Reserve drops the prime lending rate, they’re encouraging you to spend money. Savings accounts become less of a bargain while, at the same time, loans become cheaper. This encourages people to go out and buy stuff.

In terms of stocks, when it looks like people are going to be buying more in the next few months, the stock market goes up, as that means a lot of companies that sell stuff are going to be getting more business.

In short, now is a good time to start thinking about larger purchases that you may need to execute soon. If your car is having troubles, you may want to start investigating good deals on cars, for example, or if you’re looking to buy a home, consider moving forward with that process. That doesn’t mean that you should go out and spend, but instead realize that it may be a frugal time to make a necessary big purchase.

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47 thoughts on “The Fed Cuts Rates – What Does That Mean For Me?

  1. It’s proably also a godo tiem to lock into a CD. Only a few left are arounf the %5 mark and they’re disappearing fast. I found one for %5.25 APY on bankdeals. Not sure if I should do the 7 month or the 13 month.

  2. Long term fixed mortgage rates are not necessarily tied to the federal funds rate or the prime rate. It will probably take longer for them to drop in response to this.

  3. Mortgage rates are not tied to the Prime Rate but to the 10yr T-Bill. They are indirectly influenced by the prime rate.

    J

  4. We will need to buy our first home this year. In our area we can get a ranch for about 100,000. We are saving for a down payment, but only have $3000. We should have close to 10,000 by summer. Should we consider buying now, or wait til summer/fall? BTW, LOVE your blog!

  5. Thanks Jeff. I was going to make that same comment. Mortgage rates are indirectly affected by the Fed Funds Rate cut because it signals fear and problems in the economy, which cause people to want to buy bonds, so the bond prices increase and the mortgage rates and treasuries go down.
    So it’s really the fear and people pulling out of the market that cause the mortgages rates to go down.
    BTW, ING’s new rate on savings accounts is going to be 3.65% effective today. Ugh.
    I guess you can’t have it both ways, better mortgage rate and a good savings account rate. :)

  6. Does anyone know how much this will affect the Mortgage Interest ?.

    I would be interested to refinance if I can get a rate below 5%, around 4.75%

    Currently I have a 30year fix at 5.5%, which is pretty low.

    Will this cause the mortgage rates drop to that point ?

  7. Trent, two things.

    I’m fairly certain that it was the federal funds rate that went down, not the prime rate. From what I understand, banks set the prime rate, not the Federal Reserve. It’s true that the prime lending rate will drop, but that’s not what was cut by the Fed.

    Second, from what I know, the federal funds rate has no impact on fixed mortgage rates. I think (but am not certain) that it will effect variable mortgage rates, but only at the next adjustment period. Fixed-rate mortgages won’t be affected at all (or any impact will be indirect).

  8. @J.D.-
    Trent didn’t suggest that a current interest rate loan would be affected, but rather that banks might soon offer lower fixed rates that might appeal as refinancing opportunities to people who currently have higher fixed-rate loans.

  9. The Wall Street Journal printed prime rate went down today in response to the Fed funds rate change yesterday. WSJ prime is what most HELOCs and credit cards are tied to.

    The fed funds rate is now 3.5% – the prime rate is 6.5%. And Trent, you are absolutely right – the fed funds rate is the rate on short term inter-bank loans.

    The fed funds rate change does not necessarily result in a change in mortgage rates (unless you have an adjustable rate mortgage that is indexed to prime). Mortgages are long term investments and fluctuations in the short term credit market may or may not be reflected in 30-year rates.

    Mortgage rates have been trending downward for awhile, but I’m pretty sure that has more do to with market conditions than short term rates.

  10. Unfortunately the way that interest rates fluctuate is similar to how gasoline prices fluctuate. Fast to go up, slow to come down. The interest rate on your credit card most likely won’t adjust for at least 45 days as it’s usually tied to the average of the prime rate for the last 45-90 days.

    But yes this is a good thing if you have any adjustable rate consumer debt.

  11. As Jeff pointed out, fixed rate mortgages in general are tied to US treasuries – typically the same length treasury as the term of the loan. This is not something the bank normally tells a home buyer; they usually just quote a home loan rate. Commercial borrowers [those with office buildings, warehouses, etc.] know this, however, because if they get a 10-year loan, the rate is usually based on some “spread” over the 10-year treasury.

    The reason the treasury is used as a benchmark is that it is considered the most secure investment return [backed by the US govt.]. So, lenders use that as their baseline for risk and then increase the rate based upon what they see as the risk in making a potential loan. That is why people with better credit scores [less risk] get better rates – they are in reality getting a better “spread” over the treasury.

    Treasuries are indirectly impacted by changes in the Fed Funds rate. When there is market uncertainty, which this is now, that causes what is known as a “flight to quality.” Since treasuries are the least risky investment, investors will take money out of other investments and buy treasuries. This cause the price of treasuries to increase, which results in the interest rate going down. When the treasuries rate decreases, banks will typicaly lower their home mortgage rates by a similar amount.

    The treasuries have fallen substantially in the past several days and so have home mortgage rates. Some of the drop in treasuries was caused by the falling stock market, even prior to the Fed lower the Fed Funds rate.

  12. @ Bryan: When the Fed cuts rates, what they are really doing is putting more money in the economy (for the banks to borrow overnight), which helps meet demand and makes the “price”(fed funds rate) go down. The bad part is that more money in the economy = inflation!

    Trent – thanks for bringing up the car example! I’ve kind of been toying with the idea of buying a car and a cheap loan would definitely help. I totally forgot that the two were related.

  13. William asked:

    >Does anyone know how much this will affect the >Mortgage Interest ?.

    It is correlated so it may go down a bit but rates have been fluctuating a lot recently.
    You may be able to lock at 4.75% but if you are already at 5.5% I doubt that will justify the ~$3000 closing costs and the ugly hassle to refinance… depends on your balance and # years left. Also be VERY wary of fees… getting a completely straight story on a loan is VERY difficult.
    I’m refinancing my remaining $113K balance from 30 yr (22 left) 6.75% to a 15 year 5%. I calculated the breakeven point at ~3 years. If I keep the house the full 15 years I would save ~$35K in interest over putting the closing costs into my current mortgage. Of course that assumes there are no additional fees. I found out that my home owners association takes a $95 fee to refinance- the person at the title company I’m working with has see HOA fees as much as $700!
    Check out http://aplusfcu.mortgagewebcenter.com/ResourceCenter/Calculators/Default.asp?PID=76&bhcp=1 for some useful calculators.

  14. @ Jeff
    Then you wrote “hid” instead of “hide”

    @Trent
    I keep hearing about all this crazy stuff with the feds dropping rates, but didn’t really believe it til I saw it on here.

  15. Trent, I realize you aren’t an economist, but you might consider a few more posts along these lines, at least on occasion. I suspect that our lack of basic understanding about how economic policy affects the average American has a good deal to do with our spending and savings decisions/behavior. It’s useful knowledge to have, and reading it spelled out here is different than reading it buried in some article in the business section of the WSJ or NYT (and for people like PiFreak, you seem to have more cred than those publications anyway!).

  16. “In a nutshell, when the Federal Reserve drops the prime lending rate, they’re encouraging you to spend money. Savings accounts become less of a bargain while, at the same time, loans become cheaper. This encourages people to go out and buy stuff.”

    I thought it was to encourage investing? Getting 5.0% in my savings account is acceptable and I will hold a decent amount of cash. If the rate drops to 1.0% I don’t see myself increasing spending, but instead I will reduce my cash position and put a bigger chunk of my assets into the equity market.

  17. This can also have the effect of causing the dollar to further devalue, thus decreasing our buying power. You don’t get something for nothing in economic circles. The amazing thing to me is that I saw all this coming. No, I am not psychic and it was not my own ability, but Steve Forbes in his personal editorial in Forbes predicted all of this somewhere close to two years ago and he pretty much nailed what would happen, even predicting the Fed’s misguided response. But the common idea on the street is that rate cuts are good. The truth is not always that simple.

    My suggestion, spend a few minutes every other week seeking out Steve Forbes’ editorial. He’s got an amazing pulse on the economic world.

  18. Thanks, I only understood what this means now. For some time I’ve been looking for simple explanations on what those terms mean – rate cut, inflation, etc.

  19. You only give half of the picture, Trent.
    Basically what the rate decrease means for Americans day to day life is the your children will life in an America which has been sold out by their parents. With no sovereign wealth left, paying all those debts off to countries which are making this rate decrease possible.
    More: http://www.emergingsouth.net/there-is-a-limit-to-the-things-we-can-buy/

    Your scribbles are so naive. The best Americans can do is not follow the Fed’s incentives and save instead of spend. There is a limit to the things you can buy !

  20. There are downsides, too……
    I just meant to add one thing – since you calculate the savings over a 30-year mortgage. The average life span of a 30-year mortgage is much shorter (8-10 years). People move, pay off the mortgage, or refinance. So in case someone read this and wonders about a refi, think about how long you will realistically have your mortgage for before you make that decision.

  21. Actually, the Fed cut both the Fed fund rate (rate at which banks lend to each other) and the discount rate (rate at which the Fed lends to banks). The prime rate is usually set at 3% above the Fed fund rate, so when the Fed fund rate falls, the prime rate follows.

    Above commenters are right that mortgages are not directly affected by rate cuts. Most mortgages are tied to 10-year Treasuries; rates there are most directly affected by trades in the bond market and only indirectly by Fed monetary policy.

    Moreover, most subprime mortgages are tied to Libor, which is even less directly linked to Fed monetary policy because it’s not a US benchmark.

    I have a more long-winded explanation of the rate cut’s impact at my blog.

  22. “In a nutshell, when the Federal Reserve drops the prime lending rate, they’re encouraging you to spend money.” I think specifically they’re encouraging us to spend money we don’t have–borrowed money.

    My mortgage is at 6.675%, but I only have 5 years left on it, so refinancing isn’t a good idea. As Rick said, the closing costs would eat my profits.

    One thing I might look into, though. I really want to do some renovations on my house. After getting it inspected again to see what needs fixing I’d like to hire an architect to make some plans. Originally I wanted to ask for a 10- or 20-year plan, where I make changes as I can afford them. But maybe I should check into the various home improvement loan options (HELOC, refinancing a larger amount, etc.) because folks doing renovations usually have trouble getting business during recessions. Maybe now’s a good time to get some work done cheaply, even if you don’t have the money, because interest rates might be so low that you still come out ahead.

    Or maybe I’m just rationalizing.

  23. To re-iterate Kat’s question, does this affect private student loan rates? Would now be a good time to try and consolidate them? How long does it take before the rates are passed onto the loan lenders?

  24. One thing that you didn’t talk about is the inflation rate which can affect many people and is very closely related to the common interest rates.

    I don’t claim to be an expert about this, but isn’t this something that Bernake should be worried about just as much as the stock market?

  25. Thanks for this insight. There are always two sides to these changes and it’s nice to know what actions might be good to look into right now.
    I too may be in the market for a vehicle in the coming months.

  26. I love Trent’s straightforward explanation. I’m pretty sure he understands the details, but to give a simple message some things need to be simplified.

    I don’t (and AFAIK economists don’t either) believe that low rates encourage spending. Around 70% of the economy is fueled by people with 100% propensity to consume – those that live paycheck to paycheck. They weren’t saving anyway.

    In economic theory, what the rate cut will do is (hopefully) encourage companies to expand – and hiring, thus improving the economy. It could also kick up inflation – and it just might considering the rising price of food and energy.

  27. My ING Direct Orange Savings dropped yesterday by 0.45%… First time it’s been under 4% since I opened it.

  28. It won’t affect private student loans. Those rates are set by the lender and aren’t tied to any particular index. They are more like a car loan or credit card than a mortgage.

  29. Thanks for the help in digesting what the cuts mean- I just hope this economy revitilizes to rejuvanate some of the losses from my 401K! Ouch big time.
    Lisa

  30. Pingback: Tax Rebates, Economic Stimulus, and Recession - Personal Finance Review » Money Smart Life

  31. “I thought it was to encourage investing? Getting 5.0% in my savings account is acceptable and I will hold a decent amount of cash. If the rate drops to 1.0% I don’t see myself increasing spending, but instead I will reduce my cash position and put a bigger chunk of my assets into the equity market.”

    Not only are you corret but when money is cheap it creates a mirage of higher returns that wouldn’t be there under normal market conditions. So when the working Joe sees his neighbor getting 50% returns in the equity markets he dives in to reap the benefits. There then becomes a false sense of prosperity because as soon as the Fed tightens the reigns the mirage clears up and … uh ohhhh, there goes your life savings (see dot com bubble).

    The stock market then starts to stumble, the government cries foul and passes the “impossible to comply with” Sarbanes Oxley act. The Fed then cuts interest rates again to stave off a recession. Money becomes easy again and people say “fuck NASDAQ this time, I’m going to be sensible and purchase the American dream… a house. Not only does your neighbor think this is a good idea, the Prez thinks it’s a great idea too (search homeownership 2000-2003 news articles). The working Joe who lost his life savings to speculative investments and is currently renting sees his neighbor buy a house so he takes the plunge. Even though he has questionable credit there seems to be a million mortgage banks willing to give him a mortgage so he takes out a $300,000 adjustable rate mortgage and his payment is only ten bucks more than his rent.
    “Man this American Dream shit is great” he says.

    Two years later his mortgage bank comes knocking and says “Check it out, sucka! The Fed be fearing inflation and bumped the interest rates up so your payment is now going to go up 500 bucks a month. I know you can’t pay it because the other broke muthas on your block can’t pay either. I personally don’t give a shit because Bank of America, Fannie Mae and this crazy foreign dude who calls himself Hedge Fund bought all my shitty mortgages last year. I’m just here to tell you we’re taking your house so get out.

    Again the Gubment cries foul and proposes to bail out shady lenders. Not only that but they plan on cutting interest rates again to stave off recession.

    Poor Joe..he lost his life savings and his house. How come when he was deep in prosperity he didn’t hear a damn thing about shady mortgages or shady accounting but as soon as the Fed raises the interest rates and prosperity is gone the government comes to save the day with bail outs and business killing regulations?

    The moral of this long rant is buy gold and vote for Ron Paul.

  32. Pingback: Are Mortgage Rates Tied to the Federal Funds Rate? ∞ Get Rich Slowly

  33. I need to step in as I see plenty of wrong information in the comments about what drives mortgage rates. I will keep it short and to the point.

    Jeff, Pam, and Lily are wrong in claiming mortgage rates are tied to the 10-year note/Treasuries. That is a common misconception, even among mortgage professionals. Rates are derived from mortgage backed securities (mortgage bonds), namely the Fannie Mae bonds. While rates do tend to track similarly to the 10-year note, many times they move opposite.

    Furthermore, ARMs that are about to adjust may be affected by the rate cut. The reason is that the Fed’s move indirectly affects LIBOR which many rates are based on. To determine your ARM’s fully indexed rate, simply add LIBOR (or whatever else your index is based on) and the margin.

    If you would like to see what is happening in the mortgage bond market and where rates are headed, I run a blog off my main site, called Florida Mortgage Daily.

    For general mortgage planning advice, news, and more, please visit Florida Mortgage Report.

  34. joey – I believe you nailed it. Ron Paul will unfortunately never have a chance because his democratic ideas go against the corporate fascism this country is in right now.

    Terry

  35. Couple of Clarifications. I own a mortgage company.

    Most mortgage rates, whether they be fixed or adjustable, are not tied to the fed funds rate, the prime rate, or treasuries of any term.

    Many times when the fed raises or lowers “rates”, mortgage rated do the exact opposite.

    Remember, It is the reason behind the raising or lowering of “rates” by the Federal Reserve that influence mortgage rates, not the actual raising or lowering.

    Mortgage rates are tied to their underlying investments, which are Mortgage Backed Securities, or MBS. The securities trade on the open marke, like stock or bonds. Sometimes MBS follow treasuries, sometimes not. It is coincidence if they track each other, not a requirement.

    MBS use the mortgaged property as their collateral. Treasuries are backed by the US government. MBS are not. Therefore, Treasuries are considered less risky than MBS

    Some mortgages, namely Home Equity Lines of Credit (HELOCS) are tied to the prime rate, which is in fact set by banks, not the Fed. The prime rate is typically 3% higher than the fed funds rate, which is the banks overnight lending rate (the rate they lend each other money)

    Therefore, banks like to make about 3% profit spread between what they borrow the money at, and what they lend the money at.

    So, Essentially, Mortgage rates are dictated by the economy and it;s future direction. The worse the outlook, in general the better the rate. Inflation, however, will kill rates. The higher inflation looks to get, the worse (higher) mortgage rates will get.

    It is a tricky business.

  36. Troy, Luke Mullins of US News and World Report says that these rate drops will not affect 30-year fixed mortgage rates :
    “1. Fixed mortgage rates: Today’s rate cut will have little if any impact on 30-year fixed mortgage rates, which are determined by factors that operate largely outside of the Federal Open Market Committee’s reach, says Keith Gumbinger of HSH Associates. “Any change in the rate has little to do with long-term mortgage rates,” he says. But in its statement the Fed said it could expand a recently announced program to buy up debt and mortgage-backed securities from Fannie Mae and Freddie Mac that has already driven mortgage rates down to a very attractive 5.28 percent, according to HSH Associates. It also reiterated that it was looking at the possibility of buying long-term Treasury bonds. Both of these announcements could work to bring rates even lower.”

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