Free From Money

In case you’ve been in a cave the past week, the Federal Reserve called an emergency meeting on Tuesday and cut the federal funds rate by 75 basis points, the largest cut since 1990. So how does that affect you as a consumer and investor?

What do I think about the cut?

What is my own take on how this affects you? Unfortunately that is a complex topic which even a professional economist might have difficulty explaining in a short amount of time. Basically the Fed Funds rate is the interest rate that banks charge each other to borrow money. From the fed funds rate a bank’s prime rate is indexed, which is then used as a basis for other lending rates at a bank.

But the relationship between all lending rates isn’t that easy. A bank’s mortgage lending rates are typically tied to longer term rates, like the 10 year treasury rate. Why? Banks rarely keep mortgage loans on their books, choosing instead to sell them off to investors. The average life of a loan is around 10 years due to refinancing and the way that the mortgage backed bonds are created. Furthermore rates may be set based on other index rates, such as LIBOR, or public rates set in the swap market.

What does all of that actually mean?

For the most part, I doubt you are going to see a huge change in interest rates. The big risk for you is to let any salesmen convince you otherwise. Be wary of what interest rates were before and what you’re being offered now.

There is a lot of fear in the market right now (rightfully so, I think), so you will unlikely see a huge change in mortgage rates. This investors who actually own the mortgages are now expecting higher spreads than ever, which translates to higher rates.

If you have an online savings account, you have already seen a jump down in your interest rate. If you still have debt, the gap between what you pay in interest and what you earn from savings is going to grow. So it might be a good idea to focus on paying down any debt now.

Furthermore, the Fed didn’t just cut rates randomly. They called an EMERGENCY meeting, ahead of schedule, and cut their rates a huge amount. This means they are very worried about the state of the economy, and you should be too. Now is not the time to buy a new Lexus because you think interest rates are a tad lower. Keep an eye on your investment portfolios, they are likely to take a big hit in the coming months, if they haven’t already. And now, as always, is a great time to work on putting yourself into a better financial situation by paying off debt and controlling your spending.

Here are a few other posts I found regarding the rate cut:

Trent at The Simple Dollar suggests that there will be a widespread fall in interest rates, both on consumer loans and in savings rates. I have already seen the interest rate on my ING Direct savings account go down. I was happy when rates were going up, but I’m not so happy on the way down. I’m not so sure I agree with the rest of his analysis.

Blueprint for Financial Prosperity considers the refinancing into a 15 year fixed mortgage to save a ton on total interest paid, at the cost of a higher payment.

Wisebread gives a few ideas for taking advantage of the rate cut. Most of the advice involves taking advantage of lower lending rates. As I mentioned before, please be sure you compare rates before you make any big financial decisions.

Further reading:

I have already included a few links regarding the federal funds rate, the prime rate, LIBOR, and the swap market .

If you’re interested Wikipedia has a great (and long) entry on the history of the Federal Reserve system.

If you want to compare interest rates, Bankrate.com is a great resource for following both consumer loan rates as well as savings account and CD rates.

All of that should keep you busy for a while. If you want more, you should seriously consider studying economics!