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When we get approved for credit or take out anything from personal loans to a mortgage, there’s an interest rate charged against the balance that we pay down. If you’ve always regarded the process of setting these interest rates as if it were shrouded in some sort of mysticism, you could hardly be blamed. After all, we might take the occasional look at the stock market close or peek at our 401(k), but how many of us really have time to dig into the mechanics of economics or follow the markets?

This post aims to give you a look at how these rates are actually set. Although there are a variety of factors, the federal funds rate is usually a good place to start your investigation.

What Is the Federal Funds Rate?

The United States has a free market economy, but it has some controls to keep things from going off the rails. These controls are meant to prevent things like high unemployment levels and rampant inflation.

Monitoring developments in areas that impact the economy is the responsibility of the Federal Reserve. In order to keep inflation in check, the Federal Reserve is able to control the money supply. It does this, at least in part, through something referred to as the federal (or “fed”) funds rate.

The federal funds rate is the rate at which banks borrow money overnight. When the Fed wants to stimulate the economy, it will lower the short-term funds borrowing rate. In response, banks typically lower the interest rates they charge to consumers for a variety of loans. This encourages borrowing and helps stimulate the economy because you’re able to more easily get financing for big purchases like homes and cars. Lower rates also encourage businesses to borrow money to expand and build, which stimulates the economy.

However, there’s a flipside to this. If it’s cheaper to borrow money, this means the money you do have in the bank is worth less in comparison to a time when you might be receiving a higher interest rate. This can also lead to inflation because if money is worth less, it’s going to take more of it in order to purchase the things we want and need.

A little bit of inflation can be a good thing because it encourages people to buy now before the price goes up. However, you want to keep inflation relatively low because you don’t want things getting out of control to the point where you’re spending $20 on a carton of eggs. For that reason, interest rates can’t stay artificially low forever.

The fed funds rate is the Fed’s way of keeping a finger on the inflation scale.

So What’s New with the Fed Funds Rate?

Now that you know what the federal funds rate is, where does it stand? For many years after the 2008 financial crisis, the Federal Reserve kept the federal funds rate at or near 0%. This enabled banks to borrow money essentially for free, which drove lower interest rates for consumers. This in turn encourages spending on the big-ticket items that can be a boon for the economy.

However, you don’t want to overstimulate the economy and allow too much inflation. With that in mind, the Federal Reserve began raising interest rates in late 2015 and has done so seven times since, most recently last month.

The rate at which banks can borrow money overnight currently sits between 1.75% – 2%.

How Does All of This Affect Consumer Interest Rates?

Knowing what we know now, what’s the effect on the consumer when it comes to things like credit card rates and loans? Let’s dig in.

Credit Cards

While it’s possible to get a fixed-rate credit card, they’re not as popular among industry players as variable interest rate cards, because that’s where the money is for the card issuers. We’ll focus on the variable interest rate cards that most consumers have because they’re easier to find.

Credit cards involve the shortest of short-term borrowing. To avoid interest payments, a consumer has the option of paying off the entire balance every month. Because the money is lent over such a short-term, the federal funds rate heavily influences credit cards. How heavily?

If the Federal Reserve increases the federal funds rate, credit card rates go up in lockstep.

Credit card rates are tied to a prime rate, the lowest rate at which a consumer can borrow money, plus a certain percentage that’s up to the card issuer. Since the prime rate changes with the federal funds rate, this is the primary way the rate goes up.

How likely are you to notice the difference, though? The answer is not very likely.

According to one recent analysis, the average American household has $8,683 in credit card debt. Assuming a 14.99% initial interest rate, a 0.25% rate hike would take the minimum monthly payment from $101 – $102.

Of course, because the interest rates are so high, if you make the minimum payment, you’ll be paying forever and paying the greatest possible interest. If you can, the best thing to do is to pay off the balance each month.

If you have lots of credit card debt, you may find that debt consolidation is helpful.

Auto Loans

Car loans are the next ones we’ll go over because they’re also relatively short-term. A typical auto loan might be anywhere from two to five years.

However, auto loans are still traded within the free market, so they’re not directly tied to any particular rates. It’s more about movements within the bond market. They still go up because the overall cost to borrow any money rises, but not by as much as you think.

An analysis by USA Today shows that when the Federal Reserve raised interest rates in June 2017 by 0.25%, auto loan rates only increased by somewhere between 0.118% and 0.125% depending on the term of the loan.

Auto loans are much more influenced by your personal credit history.

Personal Loans

Let’s cover personal loans next because it’s another loan with a two to five year term, typically.

In order to get an idea of the effects of federal funds rates on personal loans, we looked at the behavior of personal loan rates in the short and long-term from the Federal Reserve rate using data from the St. Louis Fed. The data is based on a 24-month loan term.

So, do short-term rates have an effect on personal loan interest rates? Maybe, but maybe not.

In the months following a rate increase by the Fed, interest rates briefly popped up a bit, going from 9.66% in November 2015 to a 10.03% rate in February 2016.

However, there was a 0.81% increase in the average personal loan interest rate between August and November 2017. There was no increase in Federal Reserve interest rates at this time.

As with auto loans, personal loans are also fixed rates, so they’re not as likely to be responding to short-term interest rate pressures. Your credit and the term of your loan will determine your rate more than anything else.

Student Loans

How much your student loans will be affected by a rate hike may depend on the type of loan you have. Federal student loans are fixed and don’t react right away to movements in the markets. Rates are set periodically by Congress.

If you have student loans from private lenders, those can be either fixed or variable. If they’re variable and short-term rates go up, the interest rate on your loan will likely rise. How much depends on what index the student loans are tied to.

If you can get fixed-rate loans, that’s great. If not, you still may be able to help yourself by paying the interest early while still in college. It will keep the interest on private loans from building up during school years and during your grace period. You can also consolidate them later on if you have good credit to get a better rate.

Mortgages

There’s definitely a correlation between mortgage rates and the federal funds rate. Mortgage rates for the 30-year fixed have gone up 0.64% between August 2015 and the final reading of June 2018, according to Freddie Mac.

However, you’ll notice this is nothing like the increase of 1.75% – 2% that short-term interest rates have seen during that time. So, longer-term loans, like mortgages, don’t see the same levels of fluctuation.

In addition to the fact that the loans are fixed, most loans nowadays are traded as mortgage-backed securities (MBS) on the bond market. While traders pay attention to what the Federal Reserve is doing and prices and rates increase, there are other factors at play.

Mortgage rates are most affected by global trading movements. While this is a bit simplified, in general, when the stock market has a downturn, the bond market tends to benefit in the form of higher bond prices. This leads to a lower yield and lower rates for things like mortgages. In these situations, the guaranteed yield on bonds makes them a safer asset.

On the other hand, when stocks are booming, people sell their bonds. This is done to free up money to buy stocks. To attract investors, bond yields must be higher, which leads to higher mortgage rates.

Another thing that’s protecting mortgages from higher rates right now is that the Federal Reserve is still in the process of selling all the mortgage bonds that it brought back into the market after the 2008 crisis. At the time, the Federal Reserve stepped in to buy a bunch of MBS in order to keep mortgage rates artificially low and stimulate the economy.

Since the Federal Reserve became the biggest purchaser of MBS, now that it’s selling, another purchaser, or more likely group of purchasers, would have to bet big on MBS in order to keep rates as low as they’ve been before the Fed entered the market as part of its quantitative easing asset purchase strategy.

Hopefully this has helped you learn more about the impact of the federal funds rate on interest rates. Check out this blog post for more on the Fed’s purchases of MBS. If you still have questions, you can leave them for us in the comments below.

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