Federal interest rates have been in the news almost constantly for the past few years but you’re probably more familiar with the interest rates that you see on your credit card statements, mortgage, or car note. If you didn’t know, the federal interest rate and what you see on your statement go hand in hand.
Interest rates are the price that you have to pay to borrow some money in the form of a loan. Loans come in many forms like credit cards, car notes, or mortgages, but they always have an interest rate. Sometimes the rate is fixed, or stays the same for the life of the loan and sometimes it is variable or can change while you’re repaying the loan.
When you go to a lender to get a loan, your interest rate is calculated based on a number of factors. Some of them are in your control, like your credit score for example, but some of it is not. That’s where federal interest rates come into play.
What is the Federal Interest Rate?
Let’s start by talking about what the federal interest rate even is. When you hear someone talk about the federal interest rate, they’re typically referring to the federal funds rate, a target interest rate that is set by the Federal Reserve, the United State’s central bank (aka “the Fed”). This is the interest rate that banks charge other banks to loan them money for very short periods, such as overnight. These types of loans happen constantly so that banks have enough money to make loans, take care of their operating costs, and still have enough for you to be able to get money from the ATM all at the same time.
The Fed sets the interest rates that banks charge each other for loans by increasing or decreasing the amount of cash that is available in the banking system. It does this by buying and selling bonds on the open market which then causes the federal funds rate to go up or down.
How Does the Federal Interest Rate Work?
The Fed uses open market operations–buying and selling Treasury bill, notes, or bonds–to adjust the federal interest rate. When they sell the bills, notes, and bonds, they decrease the amount of money banks have, so rates increase. When banks have less money on hand, they are going to charge other banks more to use it.
If the Fed wants to lower interest rates, it buys bill, notes, and bonds, which puts more cash into the system. Banks then have more money and interest rates go down. It’s a simple matter of supply and demand. When the supply of something increases and the demand stays the same, it drives the prices down. Kind of like how rent tends to be higher in areas where there aren’t as many apartments available and lower in areas lots of vacant apartments to choose from.
Why Does the Fed Change the Interest Rate?
Now that you know what the federal interest rate is and how it works, let’s look at the reasoning behind why the Fed raises and lowers rates. Back when the financial crisis happened in 2008, U.S. markets weren’t doing well and there was a concern that the country could slip into an economic depression.
Depressions bring with them a whole host of bad economic indicators like high unemployment, bank failures, and currency fluctuations.
In order to head off a potential depression or prolonged recession, the Fed injected cash into the economy by buying a lot of bonds. This dropped the target rate down below 0.25% to help the slumpy economy get to growing again. When interest rates are low, it’s easier for businesses to expand and grow, hire new employees, build new buildings because the cost of borrowing is lower.
Okay, but Why are Interest Rates Going Up? I Got Bills!
Ten years later, the economy is going strong but now there’s something else that the Fed has to worry about: inflation. Did you know that Snickers bars cost just five cents each when they were first introduced back in 1930? Those were the days. Thanks, inflation.
While it would be pretty sweet if a Snickers bar still cost a nickel, some inflation is perfectly normal in a healthy economy. But too much inflation can be a problem because it can cause the prices that things cost to go up faster than wages, which makes it harder for people and businesses to afford the things that they need.
So the Fed is kind of like Goldilocks and tries to make sure that the economy isn’t too hot or too cold, but just right.
To help combat the potential downsides of too much economic stimulation, the Fed is raising interest rates. The good news is that they actually tell us what they’re planning to do so that it’s not a shocker. The Fed has signaled that by 2020 it predicts that interest rates may be higher than 3.0 percent from 2.25 in November 2018.
How Does all of This Affect Your Finances?
As the federal interest rate increases, the cost of borrowing money also increases both for businesses and for regular people. Interest rates on credit cards and other types of loans with adjustable rates will go up over time. If you have a loan with a fixed interest rate that already exists, then that won’t be affected by the rising rates. But the interest rates on new fixed-rate loans will go up when the Fed raises interest rates. So getting a brand new fixed-rate mortgage in December 2018 could have a lower interest rate than if you waited until 2020 to borrow that money.
Given that the Fed is currently considering increasing interest rates through 2020, it’s worth looking over your finances and paying close attention to any adjustable rate debts you still have. It may be worth prioritizing paying them off as soon as possible or refinancing to a fixed rate loan now while rates are still lower.
If you were thinking about making a major purchase using credit in the near future, like getting a mortgage or car loan, it might be worth bumping up your time frame to take advantage of the lower interest rates. A seemingly small interest rate fluctuation can really add up. For example, a 0.5 percent increase on a 200,000 mortgage with a 30-year term will cost you almost $20,000 extra in interest over the life of the loan.
On the plus side, though the cost of borrowing money is going to go up, the interest rate that banks are willing to pay on deposit accounts will go up too. That means that the money you have sitting in the bank will likely earn a higher interest rate as the Fed continues to increase rates. You see, banks use your deposits in two main ways: to make more loans or to meet their reserve requirements. As banks are able to make more money through higher interest loans, your deposits earn more money too. You may have already noticed that the interest rate on your savings or checking account has increased over the past year.
Now that you know what is going on with federal interest rates, you can assess your finances and decide on the best course of action, given that the Fed intends to increase the federal interest rate at least through 2020.