With prevailing high-interest rates, borrowing remains costly, while various savings avenues offer appealing rates.
Let’s take a look at the complex system that explores federal interest rates and how the rates could affect your finances.
How do interest rates work?
Interest rates can be thought of as the cost of borrowing money.
“Essentially, it’s the charge imposed by the lender on the borrower for utilizing the asset, usually presented as a percentage of the principal value,” describes Peter C. Earle, an economist and famous author at the American Institute for Economic Research.
Borrowed assets can include a car, house, business property, or cash.
Your interest rate will depend on whether you borrow money from a credit card issuer, take out a loan, or deposit money into a bank account. The annual percentage rate or APR is the annual cost of the loan and includes fees, as opposed to the interest rate.
- Credit Cards: Most credit cards specify an interest rate expressed as an APR. A credit card can have a fixed APR or variable APR for purchases that will be based on your credit score.
- Loans: Lenders impose interest charges on loans to manage risk. A loan that is secured by real estate may have a lower interest rate than an unsecured loan, such as a personal loan.
- Savings accounts: In this case, the bank pays you interest when you open a savings account and keep the funds on deposit. He can then use your money for loans.
Interest rates for savings accounts, loans, and credit cards are based on federal funds rate.
What is the Federal Funds Rate? | FED Rates
The federal funds rate is a target interest rate set by the agency Federal Reserve System – US central bank – which banks use for overnight lending. The Federal Open Market Committee of the Federal Reserve meets eight times a year, or approximately every six weeks, to determine the target range. From September 2023, the target rate is between 5.25% and 5.5%.
During a financial crisis, the Fed will lower interest rates. Lower interest rates mean cheaper borrowing and cheaper borrowing should mean more spending to help financial markets recover. More spending also tends to fuel inflation, so the Fed keeps a close eye on inflation numbers. If inflation gets too high, the Fed may decide to raise interest rates. The Fed maintains an annual inflation target of 2%, which means that goods and services become 2% more expensive each year.
All depository institutions, such as banks or credit unions, are required by the Fed to hold a certain amount of cash each night. If the cash reserve falls below this amount, one bank may borrow funds from another to meet the requirement.
Financial institutions base consumer interest rates on the Fed rate and offer what is known as the prime rate to their lowest-risk customers. This rate commonly stands at 3 percentage points above the federal funds rate, presenting the most favorable borrowing interest rate. If your credit is not ideal you should expect higher rates.
The federal funds rate is also used as a benchmark to determine the interest rates you can earn on deposit accounts. This includes savings and money market accounts and certificates of deposit. Generally, deposit rates rise and fall with the Fed rate.
What is today’s Federal Interest Rate?
At the Federal Open Market Committee’s December 2023 meeting, the rate remained in a range of 5.25% to 5.5%. The committee also raised forecasts for economic growth and lowered them for unemployment in 2024.
“The latest indicators suggest that economic activity is growing at a solid pace,” the Fed said in a statement. “Job growth has slowed in recent months, but remains strong and the unemployment rate remains low. Inflation remains high.”
DATA Source: Board of Governors of the Federal Reserve System (US) | FED FUNDS
How do interest rate changes affect you?
Changes in interest rates can have both negative and positive effects depending on whether you are trying to borrow or save. Changes in interest rates can affect whether you can afford major life purchases such as a home, car, and even a college education.
As we’ve seen over the past few years, a low-interest rate environment helps potential buyers afford mortgages and refinances. A more competitive home-buying market is also pushing up prices and fueling inflation. However, with the rise in rates, the scenario has reversed. Borrowing can be more expensive while opening certificates of deposit or savings accounts could be more lucrative.
“Small changes over a short period of time usually don’t have a big impact on individual consumers or savers,” says Earle. “But the level of interest rates over a longer period of time definitely affects the consumer’s propensity to (spend) versus save.”
It’s also worth noting that as rates rise, lenders’ dispositions change, Earle says. “This means that some lenders will increase or decrease their willingness to lend based on changes in prevailing interest rates.”
What Should You Do When Interest Rates Fall?
Seizing the opportunity of low interest rates can enhance your financial standing. You might consider doing some of these moves:
What Should You Do When Interest Rates Rise?
The loan may become more expensive. On the positive side, savings accounts should begin to yield higher returns as interest rates rise. Here are some tips to adjust to the higher rates.
Credit Cards: Work to pay off high-interest credit cards if you have balances, which will cost you more when interest rates rise and could cause you to fall into a cycle of debt.
If you need motivation to stay on track, you can use the snowball method instead. Rather than tackling the balance with the highest interest rate first, you’ll focus your efforts on paying off the smallest balance.
The snowball method may cost you more in the long run than the avalanche method, but it could pay off if you have no credit card debt.
Loans: Even a small increase in the federal funds rate could dramatically affect your ability to make a large purchase like a home.
The good news is that the Fed’s actions don’t always directly affect mortgage rates, especially for regular 30-year fixed-rate loans. Adjustable-rate mortgages are more likely to be directly affected than fixed-rate mortgages.
Several other factors also affect the mortgage rate: credit score, loan size, and amount of deposit.
Improving your credit score is a wise long-term strategy to mitigate the effect of higher interest rates on any type of loan. In general, the higher your credit score, the lower your interest rate can be.
Savings accounts: Rising interest rates are ideal for your savings account because it should be earning more money, Earle says.
“If a bank depositor aims to capitalize on increasing interest rates, it’s wise to explore savings accounts, CDs, and other instruments offering the highest rates,” he suggests.
Community banks and credit unions tend to offer some of the most competitive rates as well as online banks. Fortunately, plenty of regularly updated online rate aggregators let you search for the best savings rates with just a few clicks.
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