Download Federal Reserve And Interest Rates

Federal Reserve And Interest Rates
Understanding how interest rates are assessed will help you manage your
borrowing now as well as in the future. If you must borrow, you need to
understand the cost of borrowing and how interest is assessed.
Many individuals think the Federal Reserve control interest rates that individuals
pay when purchasing a car, finance or refinance a mortgage, use credit cards or
borrow for other purchases. However, the Federal Reserve doesn't control
consumer rates directly, but it sets the federal funds rate, which is what banks
pay to borrow money from one another.
For example, when Federal Reserve interest rates are low, banks can borrow
more money to lend to individuals. Also consumers can borrow at lower costs.
The Federal Reserve can have a drastic influence on a family’s finances just by
saying the right or wrong thing about the economy.
Let’s take a closer look at how much power the Federal Reserve has over your
financial life.
MORTAGE
The Federal Reserve DO NOT dictate what interest rate you will pay for a
mortgage. However, it does have a massive influence on what rates you could
pay.
Your mortgage interest is NOT tied directly to Federal Reserve Rates. However,
since banks need to borrow money from other banks using the Federal Reserve
rates, the rates you pay for a mortgage has an indirect cost of the mortgage
interest because, the Federal Reserve Rates impacts lenders' borrowing costs.
Brett Sinnott, director of secondary marketing at CMG Mortgage Group in San
Ramon, Calif says, "If it is more expensive for banks to borrow, they will
pass that expense on to their customers." In the current environment, any
change will have a direct, instant and negative impact on rates."
Mr. Sinnott also says, “When the Fed buys mortgage bonds and U.S.
Treasuries, it increases demand for these investments. Such purchases
tend to keep mortgage rates down. In the other direction, the Fed can
decrease demand by selling bonds, which could send mortgage rates up.”
Normally, when the economy is gloomy, mortgage rates are normally low.
However, when the economy is strong mortgage interest rates move up.
See Chart Below:
AUTO LOANS
Paul Taylor, chief economist at the National Automobile Dealers Association,
says, “As with most consumer loans, auto loans are profoundly affected by
Federal Reserve policy, but unlike credit cards or home equity lines of
credit, auto loan rates don't move in lock step with the federal funds rate.
Instead, the Fed influences rates mostly through the buying and selling of
short-term Treasuries on the open market.” Taylor also says, “When the
Fed buys Treasuries, rates on loans of similar maturities fall.”
Interest rates on auto loans are also affected by other market forces. Such as,
the market's confidence that auto loans will get paid back, the resale value of
used cars in case they don't and expectations about where inflation is headed.
See Chart Below:
CERTIFICATE OF DEPOSITS
Rates on certificates of deposit follow the Federal Reserve Rates nearly exactly.
When the Federal Open Market Committee raises or lowers the federal funds
rate, CD rates follow suit.
However, this is not always true. Dan Geller, executive vice president of Market
Rates Insight, a pricing consultant to financial institutions said, "In August 2003,
the (federal) funds rate was 1.25 percent, and the national average for CDs
was 1.91 percent. The Fed kept the funds rate flat until June 2004. For 10
months, it was unchanged, yet the market moved interest rates
independently, so the average of CDs went up to 2.25 percent, and only
after June 2004 did the Fed increase the funds rate."
When an individual purchases a CD, they are actually lending money to the
bank. In return the banks then lends the money (CD) out to other individuals or
companies. Therefore, when there is a higher demand for loans, CD rates
increase. However, banks need to make a profit, so banks leave a cushion
between the rates paid on deposits and the interest charged for loans, this is
called the net interest spread.
See Chart Below:
CREDIT CARDS, EQUITY LINES OF CREDIT, AND OTHER VARIABLE
LOANS
The Prime Interest Rate is a consensus rate set by the ten largest banks in the
United States. Commercial banks use the prime rate to set loan interest rates to
their most creditworthy customers. The prime rate is tied directly to the Federal
Reserve Rate and is published in The Wall Street Journal. The prime rate only
changes when seven of the ten largest U.S. banks changes their rates.
The prime interest rate is used to determine the interest charged on variable-rate
credit cards and home equity lines of credit. Keith Leggett, senior economist at
the American Bankers Association in Washington, D.C. says, “Lenders will add
a margin to the prime rate, such as 2 percentage points, to determine the
interest rate a consumer will pay on credit cards or home equity line of
credit.”
However, only the most creditworthy customers receive the lowest interest rates.
If you have a high credit score and a superior payment history, you will most
likely pay a low interest rate on credit cards and home equity lines of credit.
However, if you have a low credit score and blemished payment history you more
than likely will have a higher rate.
See Chart Below:
Too much debt (college, credit cards, mortgage, etc.) is very dangers. A good
rule of thumb is, only borrow enough money that will not drastically affect your
debt-to-income ratio. It is also important to remember, when you borrow money
you will pay for the privilege of borrowing the money.
If you borrow money without a realistic plan on how you will pay the debt off, it
could cause many financial difficulties. Borrowing is a form of financial slavery.