Fed Rate Cut: What It Means for You

Jan. 30, 2008— -- The Federal Reserve continued its policy of slashing interest rates in hopes of fending off a recession, cutting a key rate this afternoon by another half a percentage point.

The key Federal Funds interest rate now stands at 3 percent. It has not been this low since June of 2005.

Just a few months ago, the Federal Funds rate was 5.25 percent. This is the fifth rate cut since August when the Fed started slashing interest rates to stimulate the economy.

Just last week, the Fed held an emergency meeting and cut the rate three-quarters of a percentage point. It was the largest single downward move by the Fed since August 1982.

"Financial markets remain under considerable stress, and credit has tightened further for some businesses and households," the Fed said in a statement. "Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets."

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The stock market responded very positively initially. The Dow Jones Industrial Average was down about 30 to 40 points for most of the morning but shot up to 60 points above yesterday's close in the minutes following the 2:15 announcement. Within 10 minutes of the announcement, the Dow was up 120 points. But in the final few minutes of trading stocks fell, with the Dow closing down 40 points.

Nine members of the Federal Open Market Committee voted for the rate cut, including Federal Reserve chairman Ben Bernanke. The only vote against came from Richard W. Fisher, who preferred no change.

The move by the Fed came a few hours after the Commerce Department released new data showing just how much the economy has slowed.

In the last three months of 2007, the overall economy, measured by the gross domestic product, grew at a rate of just 0.6 percent. For all of 2007, the economy grew by just 2.2 percent, the weakest performance in five years, when the country was struggling to recover from the 2001 recession.

The numbers show that the economy is clearly slowing but that there was still growth, no matter how small.

Investors want lower rates because cheaper loans mean more borrowing and spending by consumers and businesses. With lower rates, businesses find it easier to expand.

So what about consumers?

Most people's short-term loans, such as credit card debt, are tied to the prime rate, which is generally three percentage points higher than the Federal Funds rate.

Cheaper Mortgages

Longer-term, fixed-rate loans such as mortgages and college student loans are tied to Treasury bonds, which are not directly affected by the Fed's decision. So don't expect any immediate relief. However, Treasury bonds typically take on some of the Federal Funds rate momentum and are likely to move down after this afternoon's cut.

That means people with some types of variable-rate mortgages are likely to see some more well-needed relief. It might not be enough to stop the sharp rise in foreclosures, but it is likely to help some of the people on the edge of making their payments.

But just because there are lower interest rates, it does not mean that everybody can refinance.

When interest rates were this low just a few years ago, many Americans became first-time homebuyers. Some had spotty credit and many lenders did not require documents verifying income or assets.

Many of those so-called subprime borrowers have now defaulted on their mortgages, leading to a major fallout for home sales, price and the banking industry.

Lenders have tightened their loan standards. So even with lower mortgage rates here now, many Americans can't refinance their existing mortgages. This is compounded by falling house prices, which makes it tough for even those with good credit to refinance.

Still many people are refinancing.

The Mortgage Bankers Association reported last week that refinance applications are up 92 percent since the beginning of November, while the average interest rate for 30-year fixed-rate mortgages decreased to 5.49 percent.

Many of those people are shifting from adjustable-rate mortgages to fixed-rate mortgages.

Credit Cards

Some people with an outstanding credit card balance are likely to see some relief, but not immediately.

Variable-rate credit cards are set using a formula tied to the prime rate, but most variable-rate cards don't "float." They shift at fixed times throughout the year, so it's unlikely there would be a substantial immediate impact. Also, fixed-rate cards make up the majority of the credit card market and they don't change much at all.

Also directly affected are people who have home equity lines of credit. These loans are usually tied to the prime rate so they will be directly impacted.

Car Loans

Finally, people with car loans are not going to see any relief because those rates are typically locked in at the time of the purchase. However, anybody seeking a new loan for a car purchase will likely see lower rates.

The key for any consumer is to shop around and read the fine print. So if your credit card rate doesn't lower, shop around — maybe another bank has lowered its rates.