You may not realize it, but behind the scenes the Federal Reserve is quietly influencing your everyday life when it comes to borrowing, saving and even spending. Serving as the central bank of the United States, the Federal Reserve, or Fed, is responsible for managing the country’s monetary policy. A big part of its job is adjusting the federal funds rateâthe short-term interest rate banks charge each other to lend funds overnight. The Fed decides whether or not to raise or lower this benchmark interest rate in order to reach maximum employment and stable inflation.
OK, wait. Policymakers, the economics behind employment and inflation, overnight lending between banks… so how does a change in interest rate affect your decision to spend or save, you ask? To borrow from a popular saying: âSo goes the federal funds rate, so goes consumer interest rates,” says Riley Adams, a certified public accountant and founder of personal finance website Young and the Invested. Whether it goes up or down, a change to the federal funds rate could have a ripple effect in the same direction for borrowers, savers and spendersâan important proof point for why the federal funds rate matters for consumers.
If this is news to you and the federal funds rate hasn’t really been on your radar, have no fear. What follows will help you more fully answer the question: How does the Federal Reserve interest rate affect me? Then you’ll be on your way to making the best money management decisions for your financial goals and the current interest rate environment.
A low interest rate environment makes borrowing more attractive
The answer to “how does the Federal Reserve interest rate affect me?” can be very beneficial in a low-rate environment if you have debt or are looking for new borrowing opportunities. When the Fed cuts rates, borrowing money tends to become less expensive since banks and lenders also typically lower rates on their credit products.
In a low-rate environment, for example, you could see lower rates on:
Private student loans
Home equity lines of credit
Why the federal funds rate matters for consumers and the credit cards in your wallet has to do with minimum payments and interest charges. A Federal Reserve rate cut could translate to a lower minimum payment on credit cards and a lower cost to carry a balance from one month to the next. For loans, a Fed rate cut could mean lower monthly payments and less interest paid out over the life of the loan. Lower borrowing costs can add money back to your budget that you could use to spend, save or apply to your financial goal of choice.
How does the Federal Reserve interest rate affect me when it comes to homeownership, you ask? There’s good news there, too. When the Fed lowers rates, homeowners with an adjustable-rate mortgage or homebuyers shopping for one may experience a rate reduction, since the rates for this type of mortgage typically track with the prime rate, which is in turn influenced by the federal funds rate. The lower your mortgage rate, the lower your monthly payment and the more home you might be able to afford. Good deal. Note that fixed-rate mortgages are less directly impacted by a Fed rate cut.
Chad Rixse, director of financial planning at Forefront Wealth Partners, says that when rates are falling, it may be a good time to consider refinancing or consolidating existing debt, such as private student loans, home loans and car loans. (Definitions: Refinancing means replacing your existing loan with a new one at a lower rate. Consolidating means paying off multiple loans with a single new loan.)
When analyzing “how does the Federal Reserve interest rate affect me?” Adams adds that consumers should be mindful of how much rates have dropped to determine the value of refinancing or consolidating. Using mortgages as an example: “They should not consider refinancing a mortgage after a 25 basis point (0.25%) cut in the rates because the associated costs and fees will outweigh any interest savings,” Adams says. “If rates move meaningfully lower (1.00%+), they should be on the lookout for refinancing offers, assuming they have significant time remaining on their mortgage and can benefit from lower interest costs.”
âSo goes the federal funds rate, so goes consumer interest rates.”
When rates rise, savers reap the benefits
How does the Federal Reserve interest rate affect me when rates go up? In a higher interest rate environment, your savings may actually be able to get a little more love.
“If interest rates rise, this benefits savers by possibly earning more interest on their bank deposits, assuming their bank indexes interest rates on deposits to remain competitive against other banks,” Adams says.
For your list of “ways the Fed interest rate affects me,” consider that these savings vehicles could earn more interest when rates rise:
Certificates of deposit (CDs)
Money market accounts
Interest-bearing checking accounts
You can take advantage of higher savings interest rates and get the most from your savings efforts by increasing the amount of money stashed in your interest-earning savings accounts. The higher the balance, the more you will earn.
If you’re focused on saving and there’s a chance rates could drop in the near term, you may want to lock in a higher rate while you can with a long-term, fixed-rate CD. That way, you can continue to earn a higher rate throughout the CD’s term even if the Fed cuts the federal funds rate and rates start to drop on deposit accounts.
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Interest rates can affect spending habits
Why the federal funds rate matters for consumers even extends into purchasing power and everyday spending.
âBy raising the federal funds rate, the Fed makes it more attractive for banks to hold extra capital,” says James McGrath, a housing market expert and licensed real estate broker at New York-based real estate firm Yoreevo. âWhen more money is locked away in vaults, there is less available to make loans and buy things, which slows growth and inflation.”
If inflation is kept to a minimum by the Fed’s benchmark interest rate, prices for things you buy every dayâthink groceries or personal care itemsâhave less room to increase. If a Fed rate change keeps those everyday prices low, you can put more of your money toward savings or paying off high-interest debt.
On the flip side, McGrath says the Fed can lower rates to spur spending. That puts more money into the economy, but it does open up the potential for prices to rise, he says. If you’re wondering “what ways the Fed interest rate affects me?” consider that higher prices could mean that your money has to stretch further to buy the same things.
How to handle interest rate changes
By now, you should have a better understanding of why the federal funds rate matters for consumers. While there’s nothing you can do to control the Federal Reserve’s rate changes, you can control how you react to rising or falling rates.
Look at your overall financial situation against the backdrop of what’s happening with rates. Your list of ways the Fed interest rate affects me might be different than someone else’s. Ask yourself how you can take advantage of rising or falling rates for maximum financial benefit when it comes to your borrowing, saving and spending priorities. For example, if the Fed hikes rates and you’ve been building up a college savings fund for your children, you may be motivated to put more into savings to take advantage of higher returns. If rates are cut and you’ve been in the market for a loan for some time, now could be the time to jump on it.
Note that the ways the Fed interest rate affects me may also depend on more than just one Fed rate change. “Small changes don’t amount to significant differences over time,” Adams says. “It’s when a long-term rate increase or decrease path becomes the norm that consumers should pay more attention,” he adds.
Above all, remember that rate increases and decreases are a normal part of what the Fed does. âRemain calm and carry on,” Rixse suggests. âDon’t let panic or negative emotions guide your decision-making.”
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Just about everybody with a wallet is impacted by the Federal Reserve. That means youâhomeowners and prospective buyers. Whether you’re already nestled in to the house of your dreams or still looking to find it, you’ll probably want to track what happens to mortgage rates when the Fed cuts rates. When the Fed (as it’s commonly referred to) cuts its federal funds rateâthe rate banks charge each other to lend funds overnightâthe move could impact your mortgage costs.
The Fed’s overall goal when it cuts the federal funds rate is to stimulate the economy by spurring consumers to spend and borrow. This is good news if you are carrying debt because borrowing tends to become less expensive following a Fed rate cut (think: lower credit card APRs). But in the case of homeownership, what happens to mortgage rates when the Fed cuts rates can be a double-edged sword.
The connection between a Fed rate cut and mortgage rates isn’t so crystal clear because the federal funds rate doesn’t directly influence the rate on every type of home loan.
“Mortgage rates are formed by global market forces, and the Federal Reserve participates in those market forces but isn’t always the most important factor,” says Holden Lewis, who’s been covering the mortgage industry for nearly 20 years and is also a regular contributor to NerdWallet.
To understand which side of the sword you’re on, you’ll need an answer to the question, “How does a Fed rate cut affect mortgage rates?” Read on to find out if you stand to potentially gain on your mortgage in a low-rate environment:
How a fixed-rate mortgage movesâor doesn’t
A fixed-rate mortgage has an interest rate that remains the same for the entire length of the loan. If the Fed cuts rates, what happens to mortgage rates if you are an existing homeowner with a fixed-rate mortgage? Nothing should happen to your monthly payments following a Fed rate cut because your rate has already been locked in.
“For current homeowners with a fixed-rate mortgage set at a previous higher level, the existing mortgage rate stays put,” Lewis says.
If you’re a prospective homebuyer shopping around for a fixed-rate mortgage, the news of what happens to mortgage rates when the Fed cuts rates may be different.
For prospective homebuyers: If the Fed cuts its interest rate and the 10-year Treasury yield is similarly tracking, the rates on fixed-rate mortgages could drop, “and you could lock in interest at a lower fixed rate than before.”
The federal funds rate does not directly impact the rates on this type of home loan, so a Fed rate cut doesn’t guarantee that lenders will start offering lower mortgage rates. However, the 10-year Treasury yield does tend to influence fixed-rate mortgages, and this yield often moves in the same direction as the federal funds rate.
If the Fed cuts its interest rate and the 10-year Treasury yield is similarly tracking, the rates on fixed-rate mortgages could drop, “and you could lock in interest at a lower fixed rate than before,” Lewis says. It’s also possible that rates on fixed mortgages will not fall following a Fed rate cut.
How an adjustable-rate mortgage follows the Fed
An adjustable-rate mortgage (commonly referred to as an ARM) is a home loan with an interest rate that can fluctuate periodicallyâalso known as variable rate. There is often a fixed period of time during which the initial rate stays the same, and then it adjusts on a regular interval. (For instance, with a 5/1 ARM, the initial rate stays locked in for five years and then adjusts each year thereafter.)
So back to the burning question: If the Fed cuts rates, what happens to mortgage rates? The rates on an ARM typically track with the index that the loan uses, e.g., the prime rate, which is in turn influenced by the federal funds rate.
“If the Fed drops its rate during the adjustment period, you could see your interest rate go down and, in turn, see lower monthly payments,” says Emily Stroud, financial advisor and founder of Stroud Financial Management.
Since ARMs are often adjusted annually after the fixed period, you may not feel the impact of the Fed rate cut until your ARM’s next annual loan adjustment. For instance, if there is one (or more) rate cuts during the course of a year, the savings from the rate reduction(s) would hit all at once at the time of your reset.
If the Fed cuts rates, what happens to mortgage rates for prospective homebuyers considering an ARM? An even lower rate could be in your futureâat least for a specific period of time.
“If you’re looking for a shorter-term mortgage, say a 5/1 ARM, you could save considerably on interest,” Stroud says. That’s because the introductory rate of an ARM is usually lower than the rate of a fixed-rate mortgage, Stroud explains. Add that benefit to lower rates fueled by a Fed rate cut and an ARM could be enticing if it supports your financial goals and plans.
“If the Fed drops its rate during the adjustment period, you could see your interest rate go down and, in turn, see lower monthly payments.”
Benefits of other variable-rate loans following a rate cut
If you have a Fed rate cut and mortgage rates on your mind and are a borrower with other types of variable-rate loans, you could be impacted following a Fed rate cut. Borrowers with variable-rate home equity lines of credit (HELOCs) and adjustable-rate Federal Housing Administration loans (FHA ARMs), for example, may end up ahead of the curve when the Fed cuts its rate, according to Lewis:
A HELOC is typically a “second mortgage” that provides you access to cash for goals like debt consolidation or home improvement and is a revolving line of credit, using your home as collateral. A Fed rate cut could result in lower rates for variable-rate HELOCs that track with the prime rate. If you are an existing homeowner with a HELOC, you could see your monthly payments drop following a Fed rate cut.
An FHA ARM is an ARM insured by the federal government. If you’re wondering about a Fed rate cut and mortgage rates, know that this type of mortgage behaves much like a conventional variable-rate loan when the Fed cuts it rate, Lewis says. Existing homeowners with an FHA ARM could see a rate drop, and prospective homebuyers could also benefit from lower rates following a Fed rate cut.
Refinancing: A silver lining for fixed rates
When it comes to a Fed rate cut and mortgage rates, refinancing to a lower rate could be an option if you have an existing fixed-rate loan. The process of refinancing replaces an existing loan with a new one that pays off your old loan’s debt. You then make payments on your new loan, so the goal is to refinance at a time when you can get better terms.
“If someone buys a home one year and a Fed rate cut results in a mortgage rate reduction, for example, it presents a real refinance opportunity for homeowners,” Lewis says. âJust a small percentage point reduction could possibly trim a few hundred bucks from your monthly payments.”
Before a refinancing decision is made based on a Fed rate cut and mortgage rates, you should consider any upfront costs and fees associated with refinancing to ensure they don’t offset any potential savings.
Managing your finances as a homeowner
You might be expecting some savings in your future now that you’re armed with information on what happens to mortgage rates when the Fed cuts rates. Whether you’re a homebuyer and financing your new home is going to cost you less with a lower interest rate, or you’re an existing homeowner with an ARM that may come with lower monthly payments, Stroud suggests to use any uncovered savings wisely.
“Invest that cash back into your property, pay down your home equity debt or borrow with it,” she says.
While news of a Fed rate cut may entice you to analyze how your mortgage will be impacted, remember there are many factors that help to determine your mortgage rate, including your credit score, home price, loan amount and down payment. The Fed’s actions are only one piece of a larger equation.
Even though the Fed’s rate decisions may dominate headlines immediately following a rate cut, your home is a long-term investment and one you’ll likely maintain for years. To best prepare for what happens to mortgage rates when the Fed cuts rates is to always manage your home finances responsibly and be sure to make choices that will lead you down the right path based on your financial goals.
*This should not be considered tax or investment advice. Please consult a financial planner or tax advisor if you have questions.
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