What Actually Happens When the Fed Raises Rates?

There’s a lot of confusion surrounding the Fed and what it does. According to a recent Wallet Hub survey, 16% of people think that the Fed is in charge of maintaining consumers’ credit scores, 22% think that interest rate hikes hurt their credit, and a whopping 50% think that their fixed-rate mortgages become more expensive after a rate hike (hint: all of these are untrue).

Here’s the skinny on the Fed and what happens when it raises interest rates.

What is the Fed?

Fed is short for Federal Reserve, an institution that’s responsible for keeping the U.S. banking system running and maintaining a healthy economy.

The U.S. government has an account with the Federal Reserve Bank, and uses it much as you use your checking account. Taxes and other revenues are deposited into this account, and monies are withdrawn to pay for government expenses.

The Fed also distributes U.S. currency to banks, develops laws to regulate banking (for example, it came up with the Truth in Lending Act), and generally monitors both domestic and foreign banks that operate within the U.S.

But what tends to generate the most interest in the Fed is the institution’s power over interest rates.

As part of its job to keep the economy strong and healthy, the Federal Open Market Committee (FOMC), a subset of the Fed, meets eight times a year to decide whether or not to change two key interest rates: the federal funds rate and the discount rate.

Federal funds rate

The federal funds rate is the lowest interest rate at which one bank can lend funds held at the Federal Reserve to another bank. It’s the core rate for the entire US banking industry: All other interest rates are based on this number. Thus, when the federal funds rate climbs or falls, all other interest rates tend to climb and fall along with it.

The Fed doesn’t actually control this rate (it’s set by the market), but it will announce a target for the rate and then try to manipulate the market into reaching said target by buying and selling securities.

For example, as of this writing the federal funds rate stands at 1.25%. That means that if your bank needs to borrow money, it will pay at least 1.25% interest on the money it borrows. So when the bank turns around and lends that money to you, it has to charge you a high enough interest rate to make up for the 1.25% interest the bank is paying itself, plus enough extra to make a profit on the loan.

The lowest interest rate at which banks are willing to lend money to their customers is generally referred to as the prime rate (as of this writing it’s at 4.25%). The prime rate is often used as the basis for determining a loan or line of credit.

For example, you might get a credit card offer for a card that charges “prime + 10%” in interest. What that means is that each month, the credit card issuer will look up the current prime rate, add 10%, and that’s the interest rate the card will charge you.

The Fed and your credit

The Fed and its interest rates have no direct influence on consumer credit scores or credit reports. However, rate changes can indirectly affect your credit by changing how expensive it is for you to borrow money. For example, if the Fed raises the federal funds rate and banks respond by raising their prime rates, then the interest you pay on your credit cards will go up.

That means your monthly credit card payments will go up as well, which could make it harder for you to make your payments on time. And late or missing payments would naturally have a negative effect on your credit.

Note that interest rate changes only affect variable-rate credit; any fixed rate loans that you are already holding won’t change. Since 90% of mortgages are fixed-rate, your existing mortgage is unlikely to get more expensive when the Fed raises rates.

Long-term credit products such as mortgages, auto loans and student loans are typically fixed-rate (although variable-rate options exist for all of these credit products). Short-term credit products, including credit cards, are typically variable-rate. So the next time you hear on the news that the Fed is raising interest rates, you’ll know that you should prioritize paying down your credit cards – but your mortgage is likely safe.

— Wendy Connick


Source: Motley Fool