Understanding the Fed Interest Rate and How It Impacts You

Financial Literacy Understanding the Fed Interest Rate and How It Impacts You

Sometime last week, news might have filtered to you through your favorite social media platform, feed, or blog, that the Federal Reserve lowered the Fed interest rate by 0.25%.

The announcement made on July 31st by the Federal Reserve chairman Jerome Powell was in-fact a watershed moment.  This is the first time in over ten years, since the financial crisis of 2008, our nation’s FOMC (Federal Open Market Committee) decided to lower the benchmark interest rate known as the Discount Rate. This truly was big news.

Well, what does this actually mean?

What took place has a small short-term impact on our economy but more importantly signifies a change in its long-term navigational direction. Mr. Powell and his team of highly credentialed and experienced economist have massive domestic and global influence. They are the caretaker of a powerful tool our government possesses to support our nation’s economy and well-being. They have bestowed the power to execute something called monetary policy. To quote Uncle Ben from the Spiderman series, “With great power comes great responsibility.” Monetary policy is the term used to describe the rate adjustment the board initiates by controlling what is called the federal discount rate. This rate is the rate of interest central banks would be charged to borrow money from the federal government on a short-term basis. The committee can choose to increase interest rates which supports contracting or slowing down our current economic environment. They can also do the opposite and lower interest rates like they did, which supports an expansionary growing economic environment.

Brain freeze yet? Let’s put the Econ 101 textbook down and explain in a different way.

In Simpler Terms

Think of our nation’s economy as a car tire. Monetary policy is like the pressure gauge that allows us to measure if we have the correct amount of air pressure in our tire. Expansionary policy is like taking air OUT of the tire (lowering interest rates). The opposite of this would be Contractionary policy (raising interest rates).* If money is borrowed, lower interest rates are usually more attractive. This is done to entice central banks like Bank of America, Citi, Chase, Goldman Sachs, etc. to borrow more money from the federal bank, by making the cost to borrow cheaper for them to do so. In turn, banks want to make money by lending these same funds out to businesses so they can do business things like purchase more materials or inventory, hire more workers, or support research or development, etc. Banks of course also lend to individuals so they can make major purchases such as buying a car with a car loan or a home by obtaining a mortgage, or in the most common format through credit cards. These are just some of the ways economic growth is identified and supported. These lower interest rates don’t just affect new loan origination, they affect existing borrowing products as well, ones that have variable rates of interest. Products designed for short term borrowing use are affected more directly than long term products.

So, what does this all mean for you? Here’s the impact you can expect on various types of loans, from least impacted (long-term loans) to most impacted (short-term loans**):

#4 Home Equity Lines of Credit – Perhaps in the last few years you borrowed additional funds against your house to add a pool or remodel a kitchen, consolidate some debts, or pay for some of your kids college, or other major home improvements. If so you may see your next month’s minimum interest-only payment go down slightly. Home equity lines of credit are considered short term borrowing tools therefore they are directly impacted by the federal rate change. However, their interest rates are derived from a different benchmark called the Prime Rate. The prime rate typically follows the discount rate with a few added percentage points added on top.

#3 Auto Loans – If you purchased a vehicle recently, chances are the rate on your auto loan will not change, and with a Fed reduction of only 0.25%, there is no need to rush back to your dealer to refinance, yet…Most vehicle loans have fixed monthly payments and therefore fixed interest rates after you drive off the car lot. However, if you are preparing to purchase a new (or certified pre-owned as I prefer) vehicle soon, the rates that you will be quoted should be a bit lower going forward.

#2 Personal or Business Loans/lines of credit – Personal loans can come in both fixed or variable formats depending on what you need the money for. They are typically short term in nature, therefore, rates on new fixed-rate loans could be lower going forward, as well as rates on current personal or business lines of credit.

#1 Credit Cards – Since credit cards don’t have fixed interest rates, it’s a pretty sure bet that you may soon receive an email, alert, or something in the mail from your card company that an adjustment to your credit card rate has occurred. Your rate will probably be a bit lower. However, don’t rush out to swipe or click confirm payment just yet to take advantage. Credit cards are designed to be paid off monthly, remember (insert rolling eyes emoji here). Most credit cards come with a 21 to 30-day grace period where you don’t accrue interest on your purchases during that time, meaning you pay 0%. Only when you start to carry a balance will you possibly save a dollar or two off your payment, as a result of the new rate reduction, and our readers don’t carry balances, right? So that credit card (or three) that you always have with you, now has purchasing power at a slightly lower interest rate. Not that, exciting but I will take it, how about you?

Come check out our credit card marketplace to see if there might now be a better card out there for you.

What this means for the economy

So, with the recent decrease to the federal discount rate, adjusting the rate from 3.00% down to 2.75%, does that mean the economy is not doing well? The yes and no answers are quite debatable. What I can tell you is this. Only about 8 months ago FOMC decided to increase the rate. So the fact that they have now decided to decrease the rate it signifies a sudden change in direction and strategy from our economists, relatively speaking. It is quite possible our economy is approaching the peak of its growth cycle and this change may be a maneuver to sustain growth for a little bit longer as Mr. Powell indicated in his speech, or perhaps it’s a move to prepare for a slowdown? Let’s let the pundits and talking heads bring the debate.

*Contractionary monetary policy is the opposite, like pumping air INTO the tire (raising interest rates).  Typically, the Fed will increase interest rates when the economy appears to be flourishing. Typical evidence is when unemployment is low, inflation is under control, the stock market is rising, and businesses and individuals are growing and doing financially well as a whole.  In other words, the economy has more money so it can afford to pay higher interest rates.
**Short term = <5 years
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Comments (4) Leave your comment

  1. I have been following the post by Clint Prom, and once again he gives us clear and concise information regarding what’s going on in our economy. The man is genius!!!!

  2. Thank you for a very informative and understandable document covering a complex topic Clint. I look forward to reading more from you in the future.

  3. Clint, Thanks for breaking this down to a level of detail most people can understand. Helps provide a good understanding of how I am potentially impacted.

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