Fed Interest Rates: The Truth about Lower Interest Rates

From Your Money Matters by Ken & Daria Dolan

It seems as though everyone goes crazy when fed interest rates get cut.

Just a few months ago, federal interest rate cuts were seen as good news. The Dow was up 335 points in September and jump up an additional 132 points after October's rate cuts. Google was the leading giant in this jump, as their stock price hit an historic $700 per share!

The beginning of 2008 told a different story. The Fed announced an unexpected three-quarters-of-a-percent cut because of increased fears of a recession and a sell-off in stock markets around the world. That sent the markets reeling, and the Fed said more rate cuts were likely.

They weren't lying. The Fed has now made six cuts in six months, and the market's recent initial response was positive. They are a mixed blessing. That's true with most things in life, but the Fed's decision to cut rates recently has significantly affected our wallets and pocketbooks.

Here's what this means for you and steps you should take now.

Fed Funds 101

Let's start by clarifying some of the technical jargon you've been hearing. When the Fed cuts rates, they are actually cutting the federal funds rate--the overnight lending rate that banks charge each other. This rate influences the amount of interest we pay as consumers for a variety of debt, such as credit ca5rds, mortgages, home equity lines of credit, student loans, car loans, etc. We'll get to all of those in a moment.

These rate cuts are an attempt by the Fed to decrease the impact of the current mortgage debacle. This will affect the estimated two million homeowners facing radically higher mortgage payments when their Adjustable Rate Mortgages, or ARMs, re-set to much higher payment in the near future.

This boils down to the Fed attempting to head off a flood of foreclosures across the country. The hope is, by lowering interest rates on mortgages, those folks whose rates are adjusting higher can refinance at a lower rate.

However, one of the problems with this strategy is that some borrowers who got mortgages during the "easy money" times of mortgage lending (when all of those sub-prime loans were issued), may not qualify to refinance their mortgages because credit standards have been tightened. (Daria thinks the Fed is, well, stupid, and she's not shy about saying so! See Washington Insights: The Madness Behind the Method for her, shall we say, spirited take on this!)

Bringing Washington to You

Now you know why the Fed is cutting interest rates, so let's look at how these much hyped decisions directly affect us:

Credit cards: If your credit cards have variable interest rates, you may get a break and see your rate drop slightly. You probably won't see much change in your cards with fixed rate, although some rates may start to trend a little lower.

Mortgages: We don't expect the cuts to make much of a short-term difference to borrowers, nor will they ease credit standards to make borrowing easy again. What's done is done, and a lot of people are in trouble. Honestly, it affects all of us. Get more information, including advice on what you should do if you're mortgage payment are out of reach, check out Mortgage Meltdown: What the Sub-Prime Mess Mean for You.

Car loans: Rates have already eased a little here, but don't expect any serious reduction in rates - at least not from the Fed's decision. Some auto makers are currently offering lower rates as incentives, but that's more to clear out inventory than it is because of the Fed.

Student loans: Again, if your loan has a variable rate, you will probably a slightly lower rate. But hey, you'll take it, right?

CDs/Money Market Funds: Here we see the "mixed" element of the blessing of lower interest rates. To be perfectly honest, lower interest rates means you earn less on your cash. We have serious concerns about some money-market funds in this current environment. Be sure to read our special Investor Alert for important information you need to know.

Dolan Smart Money Moves

Here are four moves we recommend you make now to get the most out of your money when federal interest rates are dropping:

1. Think of putting some of your money in longer-term CDs to lock in attractive yields before interest rates drop again. If you don't want to tie your money up for longer periods, consider three- and six-month Treasuries for short-term safety and liquidity.

2. If you have an adjustable rate mortgage, switch to a fixed-rate mortgage TODAY if you plan to stay in your home for the foreseeable future. With housing sales so weak in many parts of America, you're likely to stay put for awhile.

3. Consider opening a home-equity line of credit, but ONLY use it for emergencies. You don't owe anything unless you use it. (For more of our advice on emergency sources of money, see our Dolans' Debt Clinic Part II.)

4. Be conscious of any dates on which your student loan(s) may adjust. You're likely to see a slightly lower rate, but stay on top of it to make sure and contact your loan company if you don't get the break you're expecting.

All eyes will be on the Fed. Chairman Ben Bernanke and his associates have to be extremely careful. If they cut rates too much, they increase the risk we get on the path to another "easy money" situation that put so many lenders and borrowers in jeopardy to begin with.

We'll be sure to keep you informed and give you more tips to help you make the smartest decisions about your money.

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by Kim Stup |  03/21/08