Impact of Federal Reserve on Consumers
Here’s how moves in interest rates affect consumers…
The most important factor in any loan is the interest rate. But what happens when the U.S. Federal Reserve announces a change in the discount rate? In order to answer this question, it’s helpful to understand the three major interest rates that are affected by the Federal Reserve. Here we’ll explain those rates and their impact on consumers:
Discount Rate: The interest rate banks pay to borrow money directly from the Federal Reserve. When the Fed raises (or lowers) the cost of lending to financial institutions, the cost is eventually reflected in the interest you pay.
Federal Funds Rate: The interest rate banks pay when they borrow from each other. All U.S. banks are part of the U.S. Federal Reserve who maintains monetary stability. One way they do this is by regulating the rate banks charge one another. Most of the interest that consumers pay is tied to the federdal funds rate. The Federal Open Market Committee (FOMC) establishes the “target rate” during eight regularly scheduled meetings throughout the year.
The Prime Lending Rate: Financial institutions use the federal funds rate as a benchmark to set their prime lending rate– or the rate that their best customers are charged. The prime lending rate is typically the 3% higher than the federal funds rate. When the Federal Reserve makes changes in the federal funds rate, it directly impacts interest rates at banks.
As a good rule of thumb, you can expect interest rates (for all loan types) to eventually drop when the Fed drops the discount or federal funds rate. But this isn’t always true. For example, differences in the prime lending rate can occur when lenders shy away from lending to riskier consumers. With the current “credit crisis”, we’re seeing this now– although the Fed keeps dropping rates, mortgage rates are staying relatively flat– or in some cases even rising.
When the Central Bank cuts rates, credit cards are usually affected as well. Variable rate credit cards, those that are directly tied to a financial index, should see their interest rates decrease relatively quickly; although, it may take a billing cycle or two to show up. If your current credit card issuer doesn’t pass rate cut savings on to you, you’ll be losing out and should consider switching to another issuer.
Fixed rate credit cards, on the other hand, will see no immediate impact on interest rates after a rate cut. Since fixed APR credit cards aren’t tied to any index, issuers generally keep these rates “fixed” when market conditions are stable. But just because a credit card has a fixed rate, doesn’t mean the rate won’t change. Banks reserve the right to change your fixed APR at any time (with advanced notice). It’s likely if interest rates have made significant moves - up or down - your fixed rate will probably change to compensate.
