After interest rates spent much of 2018 on the rise – and promised to bring even higher rates in 2019 – the opposite has happened. The Federal Reserve changed direction this year and reversed short-term interest rates. 

For consumers, this is good news. Since most major purchases involve financing, lower interest rates will generally make purchases less expensive. And with rates falling across the board, this should be somewhat positive news for your wallet. 

I say “somewhat” because it will have the opposite effect on savers. As debtors get the benefit of lower interest payments, savers will experience a decline in interest income. That makes interest going down a mixed bag, depending on whether you’re mostly a debtor or a saver.

The recent history of declining interest rates

Both borrowers and lenders –and Wall Street – tend to focus primarily on the Fed funds rate when it comes to interest rates. The Fed funds rate is the interest rate the Fed charges banks for short-term loans. As a result, it forms the basis of short-term interest rates charged by the banks to their customers. 

There’s been a lot of action in the Fed funds rate over the past few years. The Federal Reserve cut the Fed funds rate to an all-time low of 0 – 0.25% by the end of 2018. The Fed left rates at that level for the next seven years, finally increasing it by a quarter-point in December, 2015. 

Through a series of fractional increases, the Fed funds rate stair-stepped its way up to the 2.25% – 2.50% level by December, 2018. But in recent weeks, the Fed reversed course, and lowered the rate by a quarter-point for the first time in more than three and a half years.

But while the Fed funds rate has a definite impact on short-term lending rates, longer-term rates can move independently. However, the trend in recent months has been a steady decline in interest rates on longer-term securities. As we’ll see in the next section, the interest rate on the bellwether 10-year US Treasury note has been declining for months, and by a whole lot more than a quarter-point.

This could be reflective of a global trend toward interest rates falling to levels not seen in human history. Right now, $13 trillion in government debt is carrying negative interest rates.

Put another way, investors are purchasing government debt securities in which they are paying the government, rather than the other way around. Negative interest debt is being issued primarily by the governments of industrialized nations. 

How lower interest rates affect mortgages

It’s often thought that mortgage rates are tied to actions by the Federal Reserve, particularly in making adjustments to the Fed funds rate. But that’s not the case. Instead, mortgage rates are determined by the interest on 10-year US Treasury notes.

And since those have been coming down substantially since late last year, interest rates on mortgages have followed suit.

According to the Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac”), interest rates on 30-year fixed-rate mortgages are currently at a near term low of 3.60%, with the 15-year fixed-rate mortgage at just 3.05%.

Freddie Mac Chart

Freddie Mac Chart

This represents a decline of more than 1.3% from the near-term high in November 2018, of 4.94% for the 30-year fixed-rate mortgage and 4.36% on the 15-year fixed-rate mortgage.

As you might expect, the interest rate pattern on mortgages follows the trend of the 10-year US Treasury note over the same space of time. The current rate (August 13) on the 10-year note is 1.68%, down from the near-term high of 3.24% in November 2018.

How lower interest rates affect mortgage payments

For the average consumer, there’s no loan type more dramatically affected by lower interest rates than mortgages. It’s long-term debt, and structured in such a way that interest is the largest part of your payment in the early years of the loan, and has a more significant effect than is the case with other types of loans.

Let’s use a $300,000 mortgage as an example

In the section above, we showed how the average interest rate on 30-year fixed-rate mortgages has dropped from 4.94% to 3.60% in a matter of a few months. How much does that affect the monthly payment on a $300,000 mortgage?

A lot.

At 4.94%, the monthly payment is $2,373. But it 3.60%, it drops to $2,137. 

That’s a difference of $236 per month or $2,832 per year.

If we add $400 per month to the payment, to cover real estate taxes and homeowner’s insurance, the total monthly payment at 4.94% will be $2,773. 

You may qualify for a higher loan

Now let’s say you have a stable monthly income of $10,000. Given that mortgage lenders typically limit your monthly house payment to no more than 28% of your stable monthly income, a monthly payment of $2,773 would enable you to qualify for a mortgage loan amount of $360,600.

By adding $400 for taxes and insurance to the payment at 3.60%, your total monthly payment will be $2,537. Again, using the 28% limit, you would qualify for a mortgage of $394,100. 

The drop in mortgage rates since last November will enable you to qualify for a loan that’s higher by $33,500.

While the prospect of lower mortgage rates can certainly make your monthly mortgage payment more attractive, it does come with a downside. In How Low Mortgage Rates Can Be Bad For Homebuyers we covered several reasons why lower mortgage rates can actually work against you. 

Bidding wars are more likely

The main problem is the increased affordability lower rates create. When rates drop, more people are able to qualify for home loans. That increases the number of people out shopping for homes. And that can result in bidding wars that cause house prices to settle at levels even above the asking price.

Property prices go up

If rates drop enough, as they have in the past nine months, it can cause a temporary surge in property prices. That holds the potential that you may be paying more for a house than you would have in 2018. 

You may pay more than you can afford

And should this rate dropped prove temporary, and mortgage rates increase in the coming months, you may find you paid a little too much for a home, based on what turned out to be temporary factors.

How lower interest rates affect credit cards

If you haven’t noticed lower interest rates on your credit cards, you’re not alone. Credit cards have been resisting the trend of falling interest rates, and even rising some as most other rates decline.

This is when it’s important to understand that credit card interest rates are set by individual banks. They don’t follow the usual pattern of moving in sync with either the Fed funds rate, or US government debt securities.

Instead, credit card interest rates are usually determined by a combination of the prime rate, plus a margin set by each credit card issuing bank. 

The prime rate generally tracks the Fed funds rate, plus a spread of about 3%. Like the Fed funds rate, the prime rate also declined by a quarter-point, falling from 5.5% to 5.25%.

But as you’ll see from the data below from the Federal Reserve, interest rates on credit cards are much higher than the prime rate. That’s because banks add a margin to the prime rate to calculate the interest you pay on your credit card.

According to data provided by the Federal Reserve Bank of St. Louis, interest rates on credit cards have reached a near-term high of 15.13%. After remaining reliably in the 12% range between 2012 and 2016, the chart below shows a steady increase since. In fact, the average interest rate on credit cards is now at its highest level since 2001.

 fredgraph_2_800x400

fredgraph_2_800x400

How lower interest rates affect home equity loans and home equity lines of credit

Home equity loans are essentially second mortgages and carry fixed interest rates and terms. Home equity lines of credit – popularly referred to as HELOCs – are something of a hybrid between second mortgages and credit cards.

Much like credit cards, the rate a bank charges is typically based on the bank’s prime rate, plus a margin.

For example, Citi uses its prime rate, plus a margin of 0.84%, in calculating both its home equity loans and home equity lines of credit.

Each individual bank will have its own formula, which is similarly the prime rate plus a margin determined by the bank. Since the prime rate is based on the Fed funds rate, a quarter-point drop in the Fed funds rate should translate into a quarter-point drop on your home equity line of credit. 

How lower interest rates affect car loans

Fed funds rate and prime rate don’t highly impact car loans

Car loans are only loosely tied to the Fed funds rate and the prime rate. While they’ll generally move up or down based on changes in either rate, the effect on the rate you’ll pay on a new car loan won’t necessarily follow exactly with either.

That’s because the prime rate, in particular, is used only as a general barometer for calculating car loans.

Secured loans are up to the banks

Unlike credit cards, car loans are secured, and therefore they’re lower risk loans. A bank may charge a basic rate for their best customers that closely matches the prime rate, or they may even charge a lower rate.

For example, even with the prime rate at about 5.25%, Bank of America is charging rates as low as 3.24% on new car loans, and 3.49% on used car loans.

Those rates will be available only to the bank’s best customers. They’ll also vary depending on the amount of the loan, the down payment you make, your credit score, income, deposits held with the bank, and other factors.

Rates may go down if you refinance

Since auto loans are fixed at the time they’re taken, the only way to take advantage of a rate reduction is to refinance your loan. But it may not be worth doing a refinance to save a quarter-point on the rate – if a bank will even offer the lower rate.

The cost of your loan won’t change much

Unlike mortgage rates, a drop in rates on auto loans won’t make a major difference in your decision to purchase a car or not.

For example, if you were to take a $25,000 loan for five years at 4.50%, the monthly payment will be $466. But with a rate of 4.25%, it will be $463 per month. The difference is just $3 per month, or $36 per year. That’s not a major motivation to purchase a new car. 

How lower interest rates affect savings rates 

High-yields will go down

While lower interest rates will generally help you when it comes to borrowing money, they’ll have the opposite effect on the saving side. As you might expect, yields on savings instruments decline with lower interest rates.

However, once again the effect of the Fed funds rate on savings isn’t as extensive as you might think.

The Fed funds rate mostly affects liquid savings vehicles, such as savings accounts and money markets. Rates on these instruments should fall about a quarter-point, if they haven’t already. 

However, given that interest being paid on savings accounts and money markets at most banks (especially local banks) are only at 0.09% and 0.19% respectively and well below the Fed funds rate, there won’t be much movement as a result of the recent rate cut. 

CDs aren’t affected

Interest rates on certificates of deposit (CDs) don’t track the Fed funds rate, and won’t be affected by reductions in that benchmark. Instead, they tend to track yields on US Treasury securities with similar terms.

Using Capital One as an example, the current yields on their one-, three-, and five-year CDs are as follows:

  • One-year – 2.40%
  • Three-year – 2.40%
  • Five-year – 2.50%

For comparison, current yields on US Treasury securities for one year, three-year, and five-year terms are 1.79%, 1.53%, and 1.51%.

As a general rule, returns on bank CDs will be somewhat higher than Treasury securities of comparable terms, since they’re considered slightly less secure than US Treasury notes, which are issued by the US federal government.

There’s not much you can do about savings and money markets with falling interest rates. But if you believe rates will continue lower, you should lock in CD rates at longer terms as soon as possible. 

Summary

Exactly how much you’ll be affected by lower interest rates will depend on whether you’re a saver or a debtor. If you’re a saver, lower interest rates will result in lower returns on your investments. But if you’re a debtor, you’ll benefit from reduced interest expense.

However, with the current round of interest rate reductions, the decline in rates isn’t going to be as dramatic as it has been in past rate declines. Certainly not to the degree of those prior to 2008, when interest rates fell from much higher levels.

Current interest rate declines are taking place only incrementally. That will result in small declines in income for savers, and small savings for debtors.

The “X factor” in the interest rate scheme is negative interest rates. Once considered an impossibility, they’re becoming increasingly popular outside the US. Should they take root here in America, interest income on savings vehicles will go negative, but rates on loans and credit cards will likely fall. Should that happen, we have to hope the drop in loan rates offsets the one in savings vehicles.

But until and unless that happens, declines in interest rates are likely to follow a slow path downward, if they continue to decline at all.

Time will tell.

Read more:

  • Savings Interest Rates Suck, But Here’s What You Can Do About It
  • Best High Yield Savings Accounts Compared