What Fed Rates Mean for You

Just this week, I’ve had three well-educated friends – ranging in age from late-20s to late-40s – ask me to tell them exactly what “the Fed” is. You think people would know this stuff. But they forget, or they’re embarrassed to ask, or they know the terms; but they don’t always understand them.

Last Tuesday the Federal Reserve reduced the rate at which banks can borrow money (the Discount Rate) by 25 basis points, a quarter of a percent. They also reduced the Funds Rate, the rate banks charge when they loan short-term funds to other banks, by a quarter.

Many in the financial community were hoping for a 50-basis point reduction for both the Discount and Funds rates. The Fed announcement was met with disappointment by Wall Street and most banking analysts. On Wednesday, a unique liquidity-focused plan was announced in consort with the Bank of Canada, Bank of England, European Central Bank, and the Swiss National Bank. Whether it will prove helpful isn't clear.

Ultimately, the Fed's actions determine the interest rate you will pay if you make a purchase using credit. Today’s Fed Funds Rate and the Prime Rate (the rate at which banks lend money to their most-favored customers) are both a full point lower than at the close of 2006.

What does this mean for you? If your adjustable rate mortgage (ARM) interest rate is based on the 12-month Treasury Average Index (MTA), it just dropped. This means any upcoming reset amount will be lower. Unfortunately, many ARM rates are tied to the LIBOR (London Interbank Offered Rate) Index. Its rates are set daily by the British Bankers’ Association. For several years, LIBOR rates remained substantially lower than Treasury rates. This made it an appealing index for short-term financing. However, the LIBOR index has been tracking in sync with the Fed recently. It has experienced equivalently high interest rate increases. This change is a major contributor to unexpectedly high mortgage reset amounts.

Fixed rate mortgage rates dropped prior to the Fed decision, making this an auspicious time to finance or refinance a home. Lending qualifications have tightened and are expected to continue in a fiscally conservative direction during 2008. Higher down payments and a return to more stringent risk-averse lending practices will make purchasing a home more difficult for some buyers. As with all credit situations, the higher your credit ratings (FICO scores), the more financing flexibility and lower loan rates you will qualify for.

Do you have a variable rate credit card? Your interest rate should be decreasing a tad. If you need to finance a car or other major purchase, the interest rate should be a little lower than it was prior to the Fed decision last week.

So, in general, this is all good news for consumers. But, as I've said, many of you have questions on how this all works -- how a single Fed decision ends up impacting the price of your car loan.

Let's begin where the problem started. In an effort to generate more revenue, banks relaxed mortgage lending practices and ended up with an unusually high percentage of borrowers with adjustable rate mortgages (ARMs). As their ARMs reset, many of these borrowers have not been able to make their payments, which is causing cash shortages for the banks. This shortfall is directly affecting the amount of liquid assets (basically cash) that banks have on hand.

Because there are federal regulations requiring banks to maintain specific liquidity levels, they must borrow money from the Federal Reserve to make up the difference when their cash reserves fall below required levels. When the Fed sets the Discount Rate low, it costs banks less to conform to regulations. When financial institutions can spend less money to acquire money, their saving is passed on to you and me. (For more in-depth information on the Fed, Forbes’ Investopedia offers clear and helpful explanations of its formation, functions, and practices.)

The next Fed meeting is scheduled for the end of January. There is already speculation that rates will be cut again. The truth: No one knows. The best thing you can do is commit to your own best credit practices so you will be prepared for whatever occurs during the long credit cruncher ahead.