The Fed recently cut interest rates, presumably to stimulate the economy. You may be wondering how that will affect you.  When the Fed “cuts rates,” this refers to a decision by the FOMC to reduce the federal fund’s target rate. The target rate is a guideline for the actual rate that banks charge each other on overnight reserve loans. Rates on interbank loans are negotiated by the individual banks and usually, stay close to the target rate. The target rate may also be referred to as the “federal funds rate” or the “nominal rate.”

The federal funds rate is important because many other rates, domestic and international, are linked directly to it or move closely with it.

Why Does It Change?

The federal funds rate is a monetary policy tool used to achieve the Fed’s goals of price stability (low inflation) and sustainable economic growth. Changing the federal funds rate influences the money supply, beginning with banks and eventually trickling down to consumers.

The Fed lowers interest rates in order to stimulate economic growth. Lower financing costs can encourage borrowing and investing. However, when rates are too low, they can spur excessive growth and perhaps inflation. Inflation eats away at purchasing power and could undermine the sustainability of the desired economic expansion.

On the other hand, when there is too much growth the Fed raises interest rates. Rate increases are used to slow inflation and return growth to more sustainable levels. Rates cannot get too high,

Financing

The Fed’s target rate is the basis for bank-to-bank lending. The rate banks charge their most creditworthy corporate customers is known as the prime lending rate. Often referred to as “the prime,” this rate is linked directly to the Federal Reserve’s target rate. Prime is pegged at 300 basis points (3%) above the target rate.

Consumers can expect to pay prime plus a premium depending on factors such as their assets, liabilities, income, and creditworthiness.

A rate cut could help consumers save money by reducing interest payments on certain types of financing that are linked to prime or other rates, which tend to move in tandem with the Fed’s target rate.

Mortgages

A rate cut can prove beneficial with home financing, but the impact depends on what type of mortgage the consumer has, whether fixed or adjustable and which rate the mortgage is linked to.

For fixed-rate mortgages, a rate cut will have no impact on the amount of the monthly payment. Low rates can be good for potential homeowners, but fixed-rate mortgages do not move directly with the Fed’s rate changes. A Fed rate cut changes the short-term lending rate, but most fixed-rate mortgages are based on long-term rates, which do not fluctuate as much as short-term rates.

Generally speaking, when the Fed issues a rate cut, adjustable-rate mortgage (ARM) payments will decrease. The amount by which a mortgage payment changes will depend on the rate the mortgage uses when it resets. Many ARMs are linked to short-term Treasury yields, which tend to move with the Fed or the London Interbank Offered Rate (LIBOR), which does not always move with the Fed. Many home-equity loans and home-equity lines of credit (HELOCs) are also linked to prime or LIBOR.

Ruth Schoenherr is a mortgage broker who will help you find home loans in the Clearwater, Palm Harbor, Largo, Safety Harbor, St Petersburg and Tampa Bay area. For more information, go to her web site at www.ClearwaterMortgageBroker.net or call at 727 447-2418.