Published in: Credit Cards | Dec. 20, 2018

How the Federal Reserve Affects the Interest Rates You Pay

Some consumer interest rates depend on the Federal Reserve’s actions, but not all of them do. Here’s a guide to help you know what to expect the next time the Fed hikes interest rates.

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The Federal Reserve is several years into a rate-hike cycle and recently raised interest rates for the eighth time since 2015. But, what does this mean to you as a consumer?

Unfortunately, there’s not one simple answer. The Federal Reserve’s interest rate activity affects only certain types of consumer interest rates directly, such as credit cards. And, while other types of consumer interest rates tend to move in the same direction as the Fed’s actions, there’s no direct correlation.

With that in mind, here’s a rundown of how the Federal Reserve’s interest rate hikes that are expected over the next couple of years could affect the interest rates you pay to borrow money, whether you’re using credit cards, taking out a personal loan, or buying a car.

How does the Federal Reserve change interest rates?

When you hear that the Federal Reserve raised (or lowered) interest rates, what it technically means is that the Federal Open Market Committee, or FOMC, decided to change its target range for the federal funds rate.

The dynamics behind the federal funds rate are a bit complicated, but the short answer is that it’s the interest rate one bank charges another bank to lend it money. When one bank holds more reserves than it is legally required to hold and another bank doesn’t have enough, the first can lend some of its excess to the second on an overnight basis. When this happens, the federal funds rate is the interest rate the first bank charges the second for this courtesy.

The prime rate

The main way that the federal fund rate affects U.S. consumers is that it determines another benchmark interest rate known as the U.S. prime rate.

The U.S. prime rate is a popular interest rate that’s often used by banks, but is not required to be used, as the borrowing rate charged to the most qualified customers. It is also the benchmark interest rate that many consumer borrowing products’ interest rates are based on, as we’ll discuss in the coming sections.

To determine the U.S. prime rate at any given time, 300 basis points, or 3 percentage points, are added to the federal funds target rate. For example, the Federal Reserve increased its target range for the federal funds rate to 2%-2.25% shortly before this writing. Adding 300 basis points to the upper end of this range gives a prime rate of 5.25%.

Over time, the prime rate has fluctuated significantly. The prime rate was stuck at a low of 3.25% from December 2008 until December 2015 and reached an all-time high of 21.5% in December 1980.

Credit cards

The most common form of consumer interest rate that is directly tied to the Federal Reserve’s interest rate moves is credit card APRs. If you take a look at your credit card’s cardmember agreement, you’ll probably see language in the APR section that looks like “The APR for purchases is the prime rate plus 15.49%,” or something similar.

In other words, when the prime rate increases, your credit card’s APR will increase by the exact same amount. For example, if the current prime rate is 5%, a card whose APR is calculated as prime plus 15.49% would have a current APR of 20.49%. If the prime rate increased to 5.25%, this card’s APR would increase to 20.74%.

The result is that when the Fed raises interest rates, it becomes significantly more expensive for you to borrow money with a credit card. For example, if you carry $5,000 in credit card debt, every 25-basis-point increase by the Federal Reserve will cost you an additional $12.50 per year in interest. So, if you have credit card debt, rising rates are yet another reason why you should make a plan to pay it off.

HELOCs

While a home equity loan can be obtained with a fixed interest rate, a home equity line of credit, or HELOC, generally comes with a variable APR that is directly tied to the prime rate.

So, whenever you initially obtain a HELOC, your APR will be set by your financial institution based on factors such as your credit score, the size of your credit line, and the loan-to-value (LTV) ratio the HELOC represents. However, it’s important to realize that this is a variable interest rate. If the Federal Reserve raises or lowers interest rates, you can expect the APR you pay on your HELOC to move accordingly.

Mortgages, auto loans, personal loans

Many other popular consumer lending interest rates such as those charged for mortgages, auto loans, and personal loans tend to move in the same direction as the federal reserve’s interest rate actions but aren’t typically directly connected to them. In other words, there’s no rule that says a bank must raise its mortgage lending rates by 25 basis points just because the Fed raised the federal funds rate by the same amount.

To illustrate this, consider that the federal funds rate has risen by 200 basis points (2 percentage points) since the beginning of 2015. During the same amount of time, the average 30-year mortgage APR in the U.S. has risen by approximately 80 basis points. And, it hasn’t been a perfect correlation -- in fact, there have been several times when the average mortgage rate dropped after a Fed rate hike.

Here’s the takeaway for you as a consumer: Just because you hear that the Federal Reserve is raising rates and is expected to keep doing so doesn’t necessarily mean that the rates you pay on mortgages, auto loans, and personal loans are going to rise along with the Fed. Chances are that these rates will increase, but the magnitude and timing of the increases is anyone’s guess.

Federal and private student loans

For student loans, it’s a little more complicated. It depends on whether you’re talking about a federal student loan or a private student loan.

Federal student loan interest rates are fixed for the life of the loan, but the fixed rates given to new borrowers change over time.

However, these interest rates aren’t based on the federal funds rate or the prime rate. Instead, since 2013, federal student loan interest rates are based on the 10-year Treasury yield, which itself is not derived from any benchmark.

Specifically, federal student loan rates are determined by the high yield of the 10-year Treasury note at the last auction held before June 1 of the applicable school year. Depending on the type of federal student loan, a certain margin is added to this rate to determine the fixed interest rate new borrowers will pay.

For example, the high yield of the 10-year Treasury note that applies to the current 2018-19 school year was 2.995% (which rounds to 3.00%). The add-on for Direct Subsidized and Unsubsidized Loans for undergraduate students is 2.05%. Adding the two together gives a fixed rate of 5.05%.

In short, federal student loans do vary over time, but while they (and the 10-year Treasury) tend to move in the same direction as the Fed’s interest rate actions, they are not directly tied to them.

On the other hand, private student loan rates can be fixed or variable, and unlike their federal counterparts, do tend to be based on a benchmark short-term interest rate. However, instead of the federal funds rate, they tend to be based on the one-month LIBOR, or the London Inter-bank Offered Rate.

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