The Federal Reserve Board announced last week that they would not be raising interest rates. All eyes seem to be on them when they meet to discuss the economy and what to do about interest rates, so it must be important. After all, the announcement sent stock soaring (though only briefly). But what interest rate is it that we’re really talking about here, and how would a rate hike affect the average consumer like you and I?
Interest Rate Types
There are actually three separate interest rates that affect the rates that you and I pay when we borrow money, and the Federal Reserve Board only affects the first two:
- Federal Funds Rate: Also known as the overnight rate, is the rate at which banks borrow money deposited in the Federal Reserve to each other.
- Federal Discount Rate: The rate at which banks can borrow directly from the Federal Reserve instead of from each other. This rate is typically higher than the Federal Funds Rate to encourage banks to borrow from each other before borrowing from the Federal Reserve.
- The Prime Rate: Set by banks, and is the rate at which banks borrow money to their best customers. This rate may vary slightly from bank to bank, and is what most consumer loans are based upon. The Wall Street Journal publishes the WSJ Prime, which is meant to be representative of what banks have their Prime Rate set to on any given day.
When the Federal Reserve Board increases the Federal Funds Rate and the Discount rate, it becomes more expensive for banks to borrow money. They pass that expense on to consumers by raising their Prime Rate, which affect the interest rate on things people borrow money for every day.
If you already have a fixed rate mortgage, there’s nothing to worry about here as your interest rate would be unaffected by a rate hike by the Federal Reserve Board. However, those aspiring to buy a home in the near future may see interest rates go up, making their payments higher and more difficult to afford.
Interest rates on automobile loans have been low for quite some time. For example, I financed my last vehicle with a 1.99% interest rate. If the Federal Reserve Board raises rates, automobile interest rates will also climb.
Credit Card Rates
Credit card interest rates are variable and based on the Prime Rate. If rates go up, so will your credit card payments. The Federal Reserve changes interest rates infrequently, so one rate hike wouldn’t cause a spike in your monthly payments. But many rate increases over time could make credit card payments difficult to handle. Also, If rates start to increase, expect to see less of those 0% interest promotional offers.
Savings Account Rates
One of the few benefits to consumers of having the Federal Reserve Board raise interest rates is that it also causes savings account rates to go up. Current interest rates on savings accounts is a mere fraction of a percent. Money sitting in a savings account actually devalues every day because the interest earned is less than the rate of inflation.
The effects of the Federal Reserve Board’s actions are complex, and how it affects the average consumer are difficult to understand exactly. The next time the news reports that interest rates may be going up, thanks to the information in this article you’ll have the tools to understand what exactly that means for you and your finances.
Do you follow the actions of the Federal Reserve Board? How would a rate increase affect your personal finances?