Changing Interest Rates & What It Means For Your Money

Interest rates affect nearly every aspect of our financial lives, from the interest rate mortgages to the returns on your savings accounts. While we often hear about "the Federal Reserve (the Fed) raising or lowering rates" in the news, the relationship between Fed policy and the rates you encounter can be confusing. This guide breaks down common questions about how interest rates work and what they mean for your money.

QUESTION: What interest rate does the Fed control?

    ANSWER: The Fed controls the federal funds rate, which is the interest rate banks charge each other for overnight lending. This rate serves as the foundation for virtually all other interest rates in the U.S. economy. A common misconception is that if the Fed lowers rates, all interest rates will lower simultaneously. The reality? While some interest rates may lower, it is unlikely that the changes happen immediately and that the rate reductions will mirror the Fed's decrease percentage point for percentage point.

QUESTION: How are 30-year fixed rate mortgage rates determined?

                ANSWER: A common misconception is that the federal funds rate directly correlates with mortgage rates in the U.S. Interest rates on 30-year fixed rate mortgages are most closely tied to the U.S. 10-year Treasury Bond. That is, the interest rate one can expect to earn by loaning the U.S. government money for a period of 10 years. While the federal funds rate may have some influence on mortgage rates, the U.S. 10-year tends to be a much better indicator. While too nuanced for the purposes of this blog post, the U.S. 10-year is influenced by expectations on: inflation, economic growth, Fed monetary policy, global economic conditions, and the overall supply and demand for Treasuries (US. Government debt).

QUESTION: What impacts the rate on my variable credit card?

                ANSWER: The interest rate called the prime rate is most responsible for determining credit card interest rates. The prime rate, in turn, is influenced by the federal funds rate, inflation expectations, demand for credit/loans, and other economic factors. As such, if the Fed increases the fed funds rate, it is likely that variable credit card rates will experience a rather quick increase. Similarly, if the Fed decreases interest rates, it is likely that variable credit card rates will decrease. As with most lending institutions, credit card companies will likely increase rates faster than they will lower them in response to a changing interest rate environment.

Note: Read my article: here on debt vs. investing for debt reduction strategies.  

QUESTION: How does the Fed lowering the federal funds rate affect my bank account interest rates?

ANSWER: A downward change in the federal funds rate creates a ripple effect that impacts the interest you earn on your savings accounts, high-yield savings accounts, and CDs – but each responds differently and at different speeds.

High-Yield Savings Accounts (HYS): The rates on HYS accounts are typically impacted most quickly and directly. While the relationship isn’t exactly 1 to 1, HYS accounts typically follow the federal funds rate path, either immediately following or in anticipation of a rate cut. If the Fed is expected to continue to lower rates, one can reasonably expect their HYS APY to lower a commensurate amount over the following weeks or quarter.

                Certificates of Deposit (CDs): Your pre-existing CDs are completely protected, as long as the CD is non-callable. However, new CDs will likely offer lower rates going forward after the Fed cuts rates.

                Traditional Savings Accounts: The rates earned on traditional savings accounts see minimal impact from Fed rate cuts, as they are typically already quite low (often under 0.50%). A Fed rate cut might push them lower, but the difference is nominal given that you are already earning very little.

Interest rates are the linchpin of the U.S. and greater global economic system. Increases and decreases to interest rates can have advantages and disadvantages depending on the amount and type of debt you have and the nature of your investments. It is best to speak with a financial professional to determine how to take advantage of changes in interest rates.