Last Wednesday, July 31, the Fed cut its rate for the first time since December 16, 2008. What exactly does this mean for my personal finances you may ask. Good question, let's break it down. A rate cut is done as a safety measure to create cushioning for the economy for what could go wrong in the future. A good analogy for the rate cut is exercising, you rarely see the effects when you are starting out but you know something is happening on the inside which will eventually manifest on the outside. The Fed will typically adjust rate to account for forecasted changes.
The FED rate.
The federal funds rate is a "monetary policy tool used to achieve the Federal reserve's (Fed) goals of price stability (low inflation) and sustainable economic growth" Investopedia. The fed cut its rate by 0.25%, this is basically a reduction in interest rates to encourage more borrowing and investing. When the Fed "cuts rates," this is indicative of a decision by the federal open market committee (FOMC) to reduce the federal fund's target rate. The target rate (also known as federal fund rate or nominal rate) is a guideline for the actual rate that banks charge each other on overnight reserve loans. Rates on bank-to-bank loans are negotiated by the individual banks and typically stay close to the target rate. As a result, changing the fed rate influenced the monetary supply because most banks practice federal reserve banking (FRB). FRB is the practice of backing a fraction, typically 10%, of an individual's deposit by cash. This means the bank reserves the right to invest the remainder at their leisure. Have you ever wondered why you have a daily withdrawal limit on your bank account? This is the reason! When the Fed rates are lowered, there is presumably more money to go around. The rate banks charge their corporate customers is known as the prime rate, which is typically about 3% above the target rate. So when the Fed cut its rates the target rate is lowered, which in turn lowers the prime rate hence more money to circulate. Let's take a deeper look at what this means for different aspects of our lives.
What exactly does this mean for your mortgage rates?
The impact of the rate cut depends on the type of mortgage. If it is a fixed-rate mortgage, the rate cut will have no effect on the monthly payments since fixed-rate mortgages are based on long-term rates and a fed rate cut affects the short-term lending rates. If it is an adjustable-rate mortgage, generally speaking, the rate cut will result in a reduction in monthly mortgage payments. The change in this payment rate depends on the rate that the mortgage uses when it resets. Most mortgages use the prime rate. Currently, mortgage rates are at a 3 year low. The average rate on the popular 30-year fixed mortgage hit 3.70% on Friday, August 2, the lowest since November 2016, according to Mortgage News Daily. According to a new tally by Black Knight, a mortgage software and analytics company, the drop last week meant that 8.2 million 30-year mortgage holders could qualify for a refinance. In this process, they could save at least 0.75% on their current mortgage interest rates. “Lower rates have also increased the buying power for prospective homebuyers looking to purchase the average-priced home by the equivalent of 15%, meaning that they could effectively buy a house worth $45,000 more while still keeping their payments the same as they would have been last fall,” said Ben Graboske, president of Black Knight Data and Analytics. This rate cut has created a more desirable environment that should be capitalized on by new home buyers and current homeowners. Lower rates present an excellent opportunity for increasing one's asset portfolio. What exactly does this mean for your auto loan rates?
Auto loans are long-term loans. Therefore, a rate cut does not immediately affect them. What exactly does this mean for your interest bearing bank accounts?
Certificate of Deposits (CD) A certificate of deposit (CD) is a federally insured savings account that has a fixed interest rate for a set time period. When a CD is purchased, the interest rate is locked in until the date the money can be taken out (maturity date). These are typically issued by banks or credit unions. For example, Chase Bank is currently offering a CD that requires a $10,000 minimum deposit, offers a 2% annual percentage yield (APY) and matures in 9 months. To qualify to purchase this CD, a qualifying chase checking account is required. Once this CD is issued, the APY is locked in and remains unaffected by economic changes. After a rate cut, there are new, lower rates available that customers can buy into. As a result, CD's are not very attractive at this time. Savings accounts
When the FOMC initiates a rate cut, banks typically lower interest paid on cash in the bank. This means customers are making less money comparatively by opting to save in a bank. Even though the effects are not seen right away, they are there. My best suggestion is that, with the exemption of your emergency fund, you invest in debt securities because during this period these are more desirable. A debt security is an interest paying asset for example, bonds. notes, and treasury bills. What exactly does this mean for credit card rates?
The effect depends on whether the credit card carries a fixed or variable rate of interest. If it has a fixed rate, there is no effect from the rate cut. However, no major credit card issuer offers fixed-rate cards since the issuance of the Credit card act of 2009. This regulation limits when credit card interest rates can be increased on existing balances, and requires 45 days notice of significant changes in credit card terms, and gives consumers at least 21 days to pay their monthly bills. Most of the provision took effect in February of 2010. It is also known as the Credit Card Accountability, Responsibility, and Disclosure Act of 2009. Some credit unions offer this card due to their member-centered focus. If it carries a variable rate, you might notice a slight reduction in interest charges because the credit cards that carry variable rates are linked to the prime rate. There is a direct correlation between the two. Today, all major credit agencies offer variable interest cards to their customers because this is more advantageous for the credit issuer.
Bottom Line
A greater understanding of how the Fed rate change affects you should allow you to make for informed investment and spending decisions.