Banking

How To Lower Interest Rates

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 12 minute read

The Federal Reserve slashed its benchmark interest rate by one full percentage point in March 2020, bringing it down to near zero, where it would remain for the duration of the COVID-19 epidemic.

This doesn’t imply that borrowers incur no costs whatsoever. Nonetheless, you should know that fluctuations in interest rates have real effects on your finances. Think of this as a crash course in how you’ll be affected by the recent drop in interest rates and what you can do about it.

The interest rate of the Federal Reserve is what.

When the Federal Open Market Committee (FOMC) lowers the target rate for the federal funds rate, it is said that the Fed has cut rates.

The target rate is one of many policy choices made by the FOMC, which meets eight times annually. When deciding how much interest to charge each other on reserve loans, banks use the target rate sometimes called the federal funds rate or nominal rate.

While the terms of each interbank loan are negotiated between the lending institution and the borrowing institution, they typically remain within a narrow range of the Federal Reserve’s target rate.

Why is it important to you what different banks charge one another?

The solution is elementary; Interest rates and other fees charged by banks to their customers are frequently based on the costs incurred by the banks themselves. They will charge you interest that is higher than the rate they pay to borrow money from another bank, in this case, 3%.

The Prime Lending Rate is the last rate deserving of discussion. The prime rate is typically three percentage points (%) higher than the target rate. This means that a target rate of 1% would translate to a prime rate of 4%. When lending money, banks charge the prime rate to their best corporate customers.

Why the Federal Reserve changes interest rates

There is a wealth of literature in the field of economics discussing this very question. For economic stimulation and higher inflation, the Fed typically reduces interest rates, while economic cooling and reduced inflation are achieved by increases in interest rates.

When rates of interest are low, both businesses and individuals can borrow money at reasonable rates. Growth in the economy is stoked by the resulting consumption and investment.

Let’s say you run a small business and have been considering building a second location. You’ve been hesitant to take on too much debt, but with interest rates at historical lows, expanding your business is now financially feasible.

You purchase a second facility on the opposite side of town, spending a considerable sum on the purchase itself, as well as on renovations, staffing, and advertising. To put it another way, all of this activity generates employment opportunities, which in turn stimulates economic expansion.

Yet if interest rates are kept too low for too long, many businesses and people will go into debt they can’t afford to repay. In other words, they are excessive spenders and debtors. This can’t go on forever.

Both individuals and businesses reach a point where they need to rein in their spending, cut back on their debt, and start paying it off. If they don’t pay them, it could cause a chain reaction of problems in the economy.

Additionally, the quick inflation that might result from so much easy money is another concern. As a general rule, prices increase when consumer demand is high. See the Federal Reserve’s chart of interest rates back to 1955 for some perspective.

In conclusion, it’s important to note that the Fed occasionally reduces interest rates for purely political reasons. In 2019, President Trump, for instance, publicly pushed Fed chairman Jerome Powell to cut interest rates via a series of tweets and press remarks.

The Effects of Lower Interest Rates on You

We don’t need any more economic theories. How do today’s reduced interest rates influence your financial situation?

Whether debt interest rates rise or fall, or investment returns rise or fall, it’s all tied to the target rate. The seven ways in which interest rates might affect your personal finances are of utmost importance to consider as a consumer and an individual investor.

1. Offers for Cheaper Credit Cards

Companies that issue credit cards borrow money cheaply from banks, usually at or close to the target rate. They will then lend it to you at significantly inflated interest rates.

With a lower target rate, they can offer you a lower interest rate while maintaining the same profit margin. When rates go up, however, card issuers have to pay more to borrow money, so they charge customers more in interest and annual percentage rate (APR).

You can choose between low-interest and high-interest credit cards at any time. However, the target rate set by the Federal Reserve changes, making both low and high relative.

2. Older Bonds Are Worth More, New Bonds Typically Pay Less

When rates drop, new issuances of government bonds typically provide lower yields. Since U.S. Treasury bonds are generally seen as a safe investment, their yields serve as a benchmark for market returns.

Bond yields on newly issued Treasuries tend to climb and fall in tandem with changes in the target rate set by the Federal Reserve.

Many new bond investors are unaware that a change in bond rates has an immediate and opposite effect on the price of outstanding bonds. The value of outstanding bonds increases when interest rates on new bonds decline.

Let’s pretend you invest in a government bond that returns 4%. When rates drop, however, newly issued government bonds pay only 3%.

All of a sudden, your 4% bond seems like a far better investment than the current 3% bonds being offered by the government. It’s possible to make a profit by selling your current bond on the open market for more than you initially invested in it.

3. Lower Mortgage Rates and Rising Home Prices

Mortgage rates, contrary to common opinion, are more closely linked to the yield on the 10-year Treasury than to the Fed’s target rate. On the other hand, as was seen above, bond yields and mortgage interest rates are both affected by the target rate. Mortgage interest rates often decrease in tandem with the Fed’s rate cuts.

Borrowers might save money each month on the same-priced home thanks to lower mortgage payments. A 30-year mortgage on $300,000 would cost $1,610 per month at 5% interest but just $1,347.13 per month at 3.5% interest.

That’s bad news because it implies housing values usually go up whenever interest rates go down. Since most buyers finance the purchase, the monthly payment rather than the total cost determines the maximum home price they can consider.

A homebuyer with a $1,610 monthly mortgage payment can afford a $300,000 property at a 5% interest rate or a $359,000 home at a 3.5% interest rate. Buyers are able to bid more on homes when borrowing rates are low, which ultimately leads to higher property prices.

Adjustable-rate mortgages (ARMs) are loans with interest rates that fluctuate with market conditions, such as the interest rate on Treasury bills. This means that the monthly payments of many existing homeowners are likewise sensitive to the ups and downs in interest rates experienced by new homebuyers and refinancers.

4. Lower rates on HELOCs

Home equity lines of credit (HELOCs) from lenders like Figure.com have variable interest rates that rise and fall with market fluctuations. If you have a home equity line of credit (HELOC) and interest rates go down, you should also see a decrease in the amount of interest you pay on your HELOC.

Many borrowers compare HELOCs to credit cards since both allow for revolving credit but HELOCs are secured by the borrower’s property.

Although home equity lines of credit (HELOCs) make it simpler to get funds, they ultimately convert to fixed-rate loans that must be repaid, so the comparison doesn’t hold up.

The comparison holds, though, when thinking about the effect of interest rates on borrowing costs. Your line of credit’s interest rate fluctuates with the market as interest rates rise and fall.

5. Lower Auto Loan Interest Rates

Auto loan rates are more frequently related to the prime rate than mortgage rates are to the yield on U.S. Treasury bonds. If the Federal Reserve decides to lower the target rate, the prime rate will also decrease, meaning that vehicle loan rates will fall swiftly.

However, just like with mortgage interest rates, borrowers can and should attempt to negotiate lower interest rates on car loans. Try to negotiate a lower interest rate on your car loan by shopping around and bartering with several lenders.

6. Your deposits are paid a lower interest rate.

The interest rate your bank pays you on your savings, whether in a high-yield savings account, a CD account, or a money market account, is likely linked in some manner to the target rate set by the Federal Reserve.

That’s bad news since it implies your liquid funds will receive less interest when rates fall. Fortunately, in the age of online banking, you can choose from a plethora of different savings accounts, making it simple to find the one that offers the most return on your money. 

Savings accounts at institutions like CIT Bank still earn competitive interest rates, even while those rates hover around 0%. Also, a booming economy is generally reflected in a rising stock market when interest rates are lowered.

7. Market Stimulus for Stocks

The correlation between interest rates and stock market values is intricate. Reducing interest rates is a strong signal that the Fed has lost confidence in the economy. When interest rates are lowered, many investors sell their shares because they believe the economy is in need of stimulus.

However, stimuli are often effective. Bringing down interest rates is like injecting the economy with adrenaline.

As was mentioned before, as interest rates are lowered, it becomes cheaper for businesses to take out loans and grow. When the Federal Reserve announces a rate cut, investors may react with euphoria rather than fear.

Bond yields play a role that only adds to the complexity. When interest rates fall, bond yields fall with them, decreasing bonds’ allure to potential buyers. As a result, many savers and investors look elsewhere, and they typically resort to the stock market.

Bond yield increases have the opposite effect, drawing money from stock markets and drawing it into the more secure bond market.

How to Benefit from Falling Interest Rates

You should now have a solid understanding of how lower interest rates can affect your finances. In the first place, remember that you shouldn’t take on more debt just because borrowing money is cheaper. 

Even though interest rates on savings accounts have dropped, that shouldn’t discourage you from putting money aside.

Cutting back on debt and ramping up one’s savings rate and investment portfolio are still the bedrock principles of building wealth. To succeed when interest rates go down, though, you might want to think about these strategies.

Think about selling your current bonds.

We’ve already established that a decline in new bond yields leads to a rise in the price of existing bonds. That’s because, after a rate decrease, existing bonds pay more than freshly issued bonds, so you may sell them for more than you paid for them.

Check the value of your bonds in light of the current low-interest rate environment and make adjustments as necessary. 

You might decide that now is an excellent moment to cash in on some of your bonds. When yields fall, it’s usually not a good time to buy bonds unless you expect rates to continue falling.

Consider stocks and real estate

As a stimulus for economic growth, lower interest rates can signal a chance to buy equities at pre-stimulus levels.

And when mortgage interest rates fall, so does the effective cost of real estate investment. After interest rates dropped, the monthly payment on the $300,000 house in the previous example dropped from $1,610 to $1,347.13.

A fixed-interest mortgage is the greatest option for financing investment properties. Locking in a low-interest rate for the next 15–30 years protects you from any future rate increases.

Care should be taken to prevent a rapid increase in housing prices. Lower borrowing rates typically lead to higher home prices since would-be purchasers are able to bid more.

A Home Purchase or Refinance

Whether to rent or buy a property depends on a number of things. When interest rates fall and your potential monthly payment for a mortgage drops, it can tilt the balance in favor of buying over renting. Despite the recent decline in interest rates, that doesn’t mean your landlord will automatically reduce your rent.

One further incentive to keep a high savings rate is so you have money for a down payment if you see a good moment to buy. If you currently own a property, lowering interest rates could make it profitable to refinance your current mortgage. Just be careful.

Refinancing is always more expensive than the loan officer makes it sound due to the closing charges, the increased length of time it takes to repay the loan, and the need to start the amortization process all over again.

Put Your Emergency Fund in Tiers

When it comes to your emergency fund, you don’t have to take the low-interest rates and lack of growth that come with them lying down. Like a medieval castle, your emergency fund should have multiple layers of protection.

As a primary backup, I have some cash stashed away in a savings account. In addition to my primary investment strategy, I always have some spare cash stashed away in my brokerage account, ready to be put to use in the event that I spot a favorable investment opportunity.

As a secondary line of defense, I have some reliable short-term investments, such as a short-term exchange-traded fund (ETF) that invests in U.S. Treasury bills. Low yields, but more reliable than my savings account.

My wife and I also have numerous unused credit cards that we can use if we ever find ourselves in a bind.

Finally, I can say that I am protected by a small but select group of exchange-traded funds (ETFs) that focus on providing reliable income. Low-volatility, high-dividend funds tend to be more stable than broad stock market indices. If I needed to, I could easily sell them without losing any rest.

If you have an emergency and don’t have enough money saved, you can use the next line of defense, which is an account that pays more than a savings account.

Move Your Credit Card Balance to a Card with a 0% Introductory APR

Credit card debt should be eliminated if it is not paid in full each month. The good news is that during periods of low-interest rates, many credit card companies provide promotions such as 0% APR on debt transfers for the first 12 to 24 months. 

Look around for a credit card that offers a lengthy introductory period with no interest charged and move any outstanding amounts over to that one.

Then, each month, put whatever you can spare into paying it off. This eliminates the need to ever pay interest on credit card balances.

Enhance Your Credit to Benefit from Cheap Financing

If you have strong credit, taking out a loan at a period of low-interest rates might save you a lot of money. Now is as good a time as any to improve credit that is less than spectacular. 

Pay off your credit card balances as a first step in improving your credit, but don’t stop there! Get out from under your high-interest, unsecured debt by using the debt snowball technique.

Check your credit report for mistakes by running it yourself. Resolving inaccurate information on your credit report is the quickest approach to boosting your score. Furthermore, millions of Americans have mistakes on their records.

When you’re ready, join Experian Boost. Including your monthly utility payments into your credit score calculation with this, no-cost service can have a significant positive impact.

Start with a secured credit card and then go on to a credit-builder loan like Self for individuals who just haven’t developed enough credit. It’s best to start building or repairing your credit as soon as possible so that you may take full advantage of low-interest financing opportunities when they arise.

Bottom Line

Since the opportunities they present are distinct from those afforded by high-interest rates, low rates can neither be considered good nor harmful in and of themselves. Bonds are a safe, high-yield investment option, particularly when interest rates are high. Their appeal typically dwindles with low-interest rates.

The same is true with low-interest rates, which reduce the cost of borrowing money but also increase the costs associated with it. 

Having a lower mortgage payment may be a benefit, but increased home prices are a consequence of this trend. Furthermore, the availability of low-interest loans frequently leads borrowers to take on more debt than they can reasonably afford.

Don’t let fluctuations in interest rates deter you from focusing on the basics of wealth creation; Get out from under your unsecured loans, up your savings rate to its maximum, and put as much of your surplus into tax-advantaged, diversified, high-yield investments as you can.

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