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Who Borrows Money And Who Lends Money At This “Target Interest Rate”

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. 9 minute read

Over a year before the start of the coronavirus pandemic, in March 2022, the Federal Reserve hikes interest rates for the first time since 2018. When the Federal Reserve Board (Fed) raises interest rates, or when it lowers them (like it did when the epidemic first reached the U.S.), what does it truly mean?

If you’re wondering, know that you’re not alone. The Federal Funds Rate appears as though it should be common sense, but it’s not. Get the lowdown on federal interest rates without the jargon.

What Is the Federal Rate of Interest?

Banks are supposed to lend money to one another overnight at the federal interest rate, sometimes known as the federal funds rate or fed funds rate. It is the yardstick by which all other loans in the economy are evaluated.

In other words, the federal funds rate is often the lowest interest rate offered by any U.S. creditor. In the case of all other commercial and consumer loans, a premium is applied to this rate. The Federal Open Market Committee (FOMC), the Fed’s governing body, decides on this benchmark interest rate at each of its eight yearly meetings.

How the Federal Interest Rate Functions

All banks are required to have a minimum balance of cash on hand. This required level of liquid assets is expressed as a fraction of their total deposits. This reserve requirement must be maintained in a deposit account at a Federal Reserve Bank.

Given the daily influx and outflow of millions of dollars at each big financial institution, it is possible for banks to conclude the day with more or less money than they are required to have by regulation. They borrow money from each other at the federal funds rate to even things out.

Banks, as you might guess, are among the least risky creditors out there. You, the customer, pose a much higher risk than a bank does. This is why banks and other lending institutions add a premium to the Fed Funds rate. Your bank may offer you 4% for a mortgage, 5% for an automobile loan, and 20% for a credit card if the government interest rate is 1%, for instance.

Lenders assess the risk associated with each form of credit and set their interest rates accordingly. Credit card default rates are far greater than those of other loan types, such as mortgages and automobile loans.

Why does the Federal Reserve change interest rates?

The Federal Reserve may either stimulate or chill the economy by changing interest rates.
Borrowing becomes cheaper when interest rates are low, and that benefits both firms and individuals by increasing their ability to spend. Generally speaking, companies have a higher profit margin when consumers spend more. The more money a company makes, the more it can afford to pay its people and put into training and advancement opportunities.

To what end, therefore, would the Fed ever seek to dampen such robust economic expansion?

Why Does the Federal Reserve Raise Interest Rates?

There will be bubbles if the economy becomes too hot. Think back to 2008 and the collapse of the housing market. One may generalize and say that mortgage rates were artificially low for too long. This was caused by a number of causes, including the method in which investment banks packaged them for sale to other investors and the way in which rating agencies undervalued their risk.

Since mortgage payments were reduced by the low interest rates, buyers were able to spend more on homes. This was especially true for borrowers with poor credit who obtained adjustable rate mortgages. Because of such, property prices in the mid-2000s were inflated artificially.

Rate increases caused people with adjustable mortgages to see their monthly payments soar. The housing market crashed as borrowers stopped making their mortgage payments, banks started foreclosing on homes, and the supply of inexpensive properties flooded the market. The bubble has, so to speak, burst.

When the Fed raises interest rates to slow economic growth, it is not just to prevent bubbles and market collapses. Inflation is reduced when interest rates are increased. They want inflation to average about 2% annually.

Hyperinflation, when it gets out of hand, may wipe out national economies, businesses, and people’s life savings. If you keep your money in cash and don’t invest in inflation-resistant assets, even moderate rates of inflation can significantly eat away at your long-term savings.

In the end, higher interest rates reduce inflation by discouraging spending and lending and increasing the attractiveness of saving.

At the end of the day, the Federal Reserve boosts interest rates to give themselves some wiggle room to stimulate economic development by lowering rates later. Leaving interest rates at zero indefinitely would deprive policymakers of one of their few effective means of stimulating the economy.

Why Does the Fed Reduce Interest Rates?

When the economy is struggling and needs a boost, the Federal Reserve reduces interest rates. Because of the decrease in the cost of borrowing money, consumers and businesses alike are more likely to do so. Our economy is driven by purchases made by individuals, and more spending makes it possible for firms to get loans for expansion.

This is why economists refer to interest rates as a “lever” that governments may employ to stimulate or chill their economies.

How to Plan for Rising Interest Rates

When rates go up, borrowing costs go up, but stock market returns go up.

Lock on low interest rates before they rise.

Before interest rates rise, borrowers with adjustable-rate mortgages (ARMs) might consider refinancing into a cheap fixed-rate mortgage. Your loan won’t need to be touched for the next 15–30 years. If you need a car loan, personal loan, or loan for your business, you may want to get one before interest rates increase.

Save more, spend less, and borrow less.

Increase your savings rate to take advantage of rising interest rates as the Federal Reserve continues to tighten monetary policy. Cut costs and increase financial commitments.

The opposite is true for borrowers: higher interest rates benefit savers and investors. Once interest rates start to take off, you shouldn’t take up any new debt unless absolutely required due to an unanticipated financial emergency or life change.

Credit Card Repayment

It’s not uncommon for credit card interest rates to follow the movements of the federal funds rate. Before interest rates increase, it is in your best interest to settle any outstanding debts.
Even with low interest rates, it’s still not a good idea to carry a balance from one month to the next. Even in the best of circumstances, the interest charged on credit cards is exorbitant because credit card firms continue to demand a huge premium on the fed funds rate.

Consider retaining old low-interest loans.

Let’s say you took out a mortgage when interest rates were low and borrowed 3%. Some years later, when interest rates have climbed, you may put your money into low-risk investments that will net you 4%, 5%, 6%, or even more.

Your monthly mortgage payment is quite low, and you’re debating whether to invest the rest of your money. In terms of guaranteed returns, paying off your mortgage early guarantees you a rate of return equal to your interest rate with zero downside risk. Instead, you might make 6% on a very safe municipal bond, thus doubling your return for a somewhat higher level of risk.

Invest in Cash-Rich Businesses

The cost to borrow money increases when interest rates rise. Companies with high debt loads that rely on a regular stream of credit will feel the effects of this.

Debt levels are not always high for businesses, and some don’t have any at all. Finding businesses with low debt-to-equity (D/E) ratios is a good strategy for stock pickers. As opposed to firms with significant debt loads, they benefit from an increase in interest rates.

Think of bond or CD ladders.

If you anticipate that interest rates will continue to rise, one strategy is to invest in a number of shorter-term bonds or CDs and roll over the maturing funds into newer, higher-yielding bonds or CDs.

This method, known as a bond or CD ladder, allows you to take advantage of gradually increasing interest rates.

Get Ready for a Recession

Recessions can be caused by a rise in interest rates. You should organize your finances while the economy is strong.

Focus on increasing your income rather than spending it, especially once you’ve paid off your obligations and established an emergency fund. How risky do you feel working there? Have you been considering a new line of work recently? Improve your résumé and increase your efforts to make professional connections.

Whether or not a recession occurs, you may improve your chances of making a job change that will benefit you financially or get you closer to your ideal lifestyle.

How to Benefit from Lower Interest Rates

With borrowing rates at historic lows, comes a new set of possibilities and perils. When the Fed announces further rate cuts, keep these considerations in mind.

Secure Low Rates After Their Decline

Consequently, as interest rates decline, it may be a good time to purchase a property or refinance an existing mortgage. Lock in your low interest rate for the duration of your loan with a 15- or 30-year fixed-rate mortgage.

However, you should stay away from trying to time the market. Don’t put off buying a house if you’re ready to do so now, even if interest rates were to drop. Home values may rise even more if interest rates were lowered.

Real Estate Investing

Real estate investments become more cost effective when interest rates decline. If you want to increase your rental income or decrease your expenses during a property flip, you may borrow money cheaply. Renting out a property is a great way to hedge against inflation and earn extra money on the side. If you have enough of it, you may use it to replace your wage and retire early.

Consider Borrowing to Help Your Company Grow

A decrease in the cost of credit creates an opening for growing companies to raise much-needed funding.

To increase marketing efforts or enter new areas, you may need to hire more people. Even if you can get a loan at a reasonable interest rate, you should be aware of the additional danger that debt poses to your company.

Look for Bond Substitutes

When interest rates are low, bond returns suffer. I’ve been trying to find alternative ways to generate passive income in order to retire early and live well. My real estate cash-flow investments include more than just rental homes.

I invest in crowdfunding websites dedicated to real estate like Fundrise and Streitwise. When investing, I like to put my money into REITs that are open to the public (REITs). I use sites like Groundfloor and invest directly in hard money loans backed by real estate.

Diversify your portfolio beyond real estate and into equities. If you’re looking for a steady stream of money, you might choose to invest in exchange-traded funds (ETFs) that have high dividend yields.

Invest for Profit

If the Fed wants to boost economic growth, it will decrease interest rates. This isn’t guaranteed to work, but it usually does. Think about putting your money in sectors that are expected to expand rapidly, like the IT industry.

Don’t bother with stock picking; instead, invest in exchange-traded funds (ETFs) focused on the growing market. As an alternative, you might invest in large-cap stock index funds.

The stock market typically generates returns of 10% per year on average over the long term. Default on U.S. debt is a potential danger. Although the interest rate on Treasury bonds is very low at 2% per year, even a small investment in them would be a risky proposition. Inflation of 2% is what the Fed hopes to see, after all.

Prospects for development can also be found in other parts of the world. Having seen life in many developing nations, I am convinced that the rest of this century’s economic development will emanate mostly from emerging economies. In the same vein, I have a larger allocation to developing market exchange traded funds than the average American.

Bottom Line

Borrowing costs for nearly all loan types are correlated with the federal funds rate. That’s why you need to pay attention to the Fed’s interest rate: it affects your bank account.

However, this isn’t the only criteria that determines the interest rate you’ll pay on a mortgage, auto loan, or credit card. Raising your credit score, saving ratio, and emergency fund will make you a more desirable borrower.

A better credit score improves your chances of receiving favorable loan conditions, regardless of the interest rate set by the federal government.

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