How is the FED Rate Cut Going to Affect Me?

How does a FED rate cut affect a common man?

1 Answer

How a Federal Reserve rate cut affects you depends on a myriad of factors. The state of the current economy, your personal situation, and the situation surrounding the Fed cut. Lets start from square one:

The Federal Reserve has the ability to move the Federal Funds Rate. This is the rate that banks charge each other on overnight loans to meet Federal reserve requirements. Each bank is required to have a specific amount of reserves deposited with the Fed. If a bank needs to borrow overnight to meet that requirement on any given day they can do this at the Fed Funds rate. In this sense, the Federal Funds rate has no bearing on an individual.

The way a cut comes in to play with an individual is that the Fed Funds Rate is the basis for Prime Rate. Fed Funds plus 3% = Prime Rate. Prime Rate is, by loose definition, the rate banks charge their best customers for short term loans. Many personal loans are based on Prime. Most all Home equity lines of credit, some credit cards, and indirectly, auto loans are all affected by Prime Rate.

Also certain savings rates are tied to Prime. Money Market accounts, CD rates etc will all tend to move up and down with Prime Rate. In this case, when the Fed cuts the funds rate, Prime moves down in lockstep. Variable loans like HELOC's will then adjust the first day of the next month according to the new Prime Rate. Lower interest also equals lower payments, so in that sense, if you had a HELOC, a drop in Fed Funds will lower your rate of interest. It is also a barometer as a whole of short term lending markets. A falling Fed Funds rate, in a macro sense, suggests a market where interest rates as a whole are falling.

In a much more specific sense, as it pertains to mortgage, the Fed Funds Rate, and Prime Rate, have NO direct bearing on first mortgage rates. In fact, depending on the market, in the time immediately following a rate cut, mortgage interest rates can move up! This gets a little complicated, but think of it this way:

Mortgages are long term financial vehicles. Many are 30 years. If you were to invest $100,000 today in a fixed investment, for a rate of return of, say 6%, you will receive a return over the life of the investment. If you had made that 30 year investment, what you would not want is inflation. This is because inflation erodes the value of the dollar.

Think of it this way, if you had $100 in 1978, or $100 today, when did you have more buying power? In 1978 of course. This is due to inflation, costs go up and prices follow them up. Therefore, the further you get into your 30 year investment, the more likely your return becomes less and less valuable if we are experiencing even mild inflation. Because of this reason, mortgage bonds, and therefore mortgage rates, HATE inflation.

Lowering short term rates (Fed Funds, Prime) is designed to spur the economy. An economy that is picking up steam is much more susceptible to inflation. Because of this, in a normally functioning economy, barring other outside influence, a cut to Fed Funds is typically a bad thing for mortgage rates. In time (sometimes a few days, sometimes a few weeks or even months), mortgages typically recover from the cut and many times, if in a truly declining rate market, go even lower than before the cut. However, more times than not, a Fed Funds cut negatively impacts mortgage rates in the immediate short term.

On the flip side, a Fed cut doesn't always mean that mortgages will react negatively. In this case, the recent Fed cut in December 2008 to a Fed Funds target of 0-.25 sparked mortgage rates lower. This was because, for one, there is little fear of inflation right now. Additionally in the subsequent Federal Reserve statement, the Fed stated that they would do everything in their power to keep mortgage rates low. This was good news for mortgage buyers, and spurred rates lower immediately after the announcement. This is another confusing example of why there is no 100% answer to your question. Much of the answer depends on the economy surrounding the Fed cut, as well as your position at the time. For example, if you were a homeowner with a Prime based HELOC, a Fed cut is almost always a good thing as your rate will go down. If you are shopping to buy a home, a Fed cut can sometimes be good, or sometimes be bad, depending on situation surrounding the cut.