When the U.S. Federal Reserve lowers interest rates, both borrowers and savers may feel the effects on their finances.
In response to the spread of COVID-19, the U.S. Federal Reserve has made two emergency interest rate cuts. While federal interest rates can affect rates on credit cards and auto loans, the cut may also influence the decisions you make around mortgages, savings vehicles, and more.
During uncertain times, it’s helpful to understand why and when the Fed decides to lower — or raise — the federal interest rate, and how Fed rate cuts may typically influence your saving and borrowing decisions.
Why does the Fed raise or lower interest rates?
The Fed has the responsibility of controlling inflation and maintaining economic stability in the U.S. In order to accomplish that, the Fed can raise or lower interest rates, which sends a ripple effect through the economy, affecting everything from savings account interest to borrowing rates.
Rate changes are usually made in response to trends in the economy. When the economy is strong, the Fed may raise interest rates to increase the cost of borrowing and ease inflation. As the economy slows or threatens to slow, the Fed may lower rates to try and boost the economy by encouraging people to borrow, spend, or invest. For savers, this may mean lower payouts. For borrowers, this may mean lower interest payments. Keep in mind, you won’t likely see these changes over night. Instead, changes may occur over weeks, or months.
How does a Fed rate cut affect borrowing?
Typically, the lower the interest rate, the cheaper it becomes to borrow money. Therefore, in a low-rate environment, you may elect to borrow when you would have otherwise paid upfront.
Mortgage rates are not directly tied to the federal funds rate. Still, they may be influenced by the rate cut. If mortgage rates drop, you may elect to take out a mortgage rather than pay in cash, allowing your liquid assets to continue working for you elsewhere — for example, in stocks, bonds, private equity or other investments.
In today’s turbulent environment, mortgage rates haven’t behaved typically. Instead, mortgage rates have fluctuated from day to day, falling and then rising once again as large banks and lenders were overwhelmed by the demand for refinances.
Interest rates on home equity lines of credit (HELOCs) are often tied to the prime rate — the rate that banks charge to their preferred customers with high credit scores — so they may drop as the Fed cuts the federal interest rates. In a low-rate environment, some may decide to use a HELOC to help fund large expenditures and keep their cash invested elsewhere.
How does a Fed rate cut affect saving?
When the Federal Reserve lowers interest rates, it may prompt banks to lower the annual percentage yields (APYs) on certain products, such as savings accounts. As the yields fall for savings vehicles such as savings accounts and money market accounts, funds invested into those accounts won’t earn as much for the foreseeable future.
During a time of market volatility, some may look to certificates of deposit (CDs) to help diversify their portfolio. Yields on CDs typically fall when the Fed cuts rates, as well. However, these yields are also influenced by broader conditions such as the 10-year Treasury yield.
To further minimize risk, you may consider CD laddering — a savings strategy where you spread a sum of money across multiple CDs with varying maturity rates. This strategy may help you lock in APYs across multiple CDs, so your investments will mature at different points in time. As each CD matures, funds will become available to use or rollover into new CDs.
Bonds tend to be another attractive option for saving money in a low interest rate environment, as their fixed returns may help lower a portfolio’s overall risk. However, amid continuing low interest rates, especially for U.S. Treasuries, bond yield can be frustratingly hard to come by.
“Investors might look alternatively to investment grade corporate bonds,” explains Alan McKnight, Chief Investment Officer for Regions Asset Management. “With the recent pullback in yields and higher spreads over Treasuries, high-quality corporate bonds could offer enhanced yield without taking on undue risk.”
As you navigate the current financial environment, now may be a good time to speak with your advisor about ways to strengthen and balance your financial strategy for the time ahead — always with a view to your long-term objectives.
