On September 18th, the U.S. Federal Reserve lowered its targeted Effective Federal Funds Rate (EFFR) – the rate at which banks borrow and lend each other money- by 0.5% from 5.25-5.50% to 4.75%-5.00%. The Fed also signaled a potential additional 0.5% rate decrease at the next Federal Reserve meeting, which takes place in early November. This is the first Fed rate cut in a number of years, and declining rates will have a direct impact on consumers, with winners and losers. In this article, I wanted to highlight a few of those impacts and actions for readers to consider making.
What is the “Fed Rate” and why is it Important?
The Effective Federal Funds Rate, or Fed target rate, is the rate at which banks borrow and lend each other money, which has a huge impact on economic activity. It’s one of the few levers the federal government has in influencing the economy. The Fed rate directly or indirectly impacts interest rates for every just about every lending transaction in our economy, including deposit rates, mortgage rates, credit card APRs, student loans, business lending, auto loans, and more.
The Fed typically targets keeping consumer inflation around a 2% annual target rate. In simplistic terms, when inflation is declining to around this target, the Fed usually lowers its target interest rate to begin increasing economic activity. When inflation begins to exceed this target, the Fed usually increases its target interest rate to slow down economic activity.
That said, we’re now in a period of declining Fed interest rates, and there are a few moves you may want to consider making in the short and long-term.
1. Lock in High CD Rates ASAP
The last few years have been a bit of a boon for those seeking solid, guaranteed rates from their savings. CDs, in particular, have been one of my favorite low-risk investment alternatives to stocks in the last 2 years. And, the guaranteed rates for a specified term makes them preferable to similar alternatives like money market funds and high-yield savings accounts in a declining interest rate environment. For big savers who like guaranteed returns, declining deposit rates are… sad face. Locking in rates via guaranteed CD terms is probably most time-sensitive move to make in a new era of declining Fed rates.
CD rates often change within a few days to a few weeks after a Fed rate change. This means that there is a small window of time right now to lock in a CD rate before they drop. Some banks and credit unions have already lowered their rates, and the rest will soon follow. I’ve already noticed that brokered CDs (offered by banks in brokerage accounts) have already all dropped – some even more than 0.5% already. Take a look at the CD rates available for purchase in Vanguard (as of 9/25/24), for example:
Rates on non-brokered CDs can still be found near 5% and higher, but you’ll have to hunt for and open them directly through banks and credit unions. CDvalet.com and depositaccounts.com are 2 good sources for this. Make sure you only purchase “non-callable” CDs, which have rates that are set for the entire specified length of the CD term. “Callable” CDs can be redeemed by the bank at any time when they become unfavorable to the bank, e.g. when rates decline. Also, avoid “variable rate” or “indexed” CDs, as their rates are not guaranteed and can change at any time.
Why urgently bother with CDs? With rates still to be found at highs of around 5% and the CPI (measure of consumer inflation) at 2.5% and declining, there’s currently still a decent spread between deposit rates and current inflation rates, but I don’t expect that to last too much longer.
2. Pay Off High Interest Debt Faster (and More Strategically)
Credit card APRs have been at historical highs in recent years, and currently sit at just under 25%, on average. A Fed rate decline will likely lower credit card APRs some, resulting in faster credit card balance payoffs for those holding them. However, there’s a better strategy here.
At current APRs, there really is no better guaranteed investment (beyond getting matching funds on retirement contributions), than paying off credit card debt. Professional investors would kill for a guaranteed 25% return in the market. If paying off your balance in full is not possible, the next best steps are:
- Look for a card with a 0% APR on balance transfers. Why pay 25% when you could be paying 0%? (watch out for balance transfer fee amounts)
- Use a lower interest personal loan to pay off your credit cards in full.
- Negotiate a lower APR with your credit card provider(s). It’s not uncommon to negotiate a 5% or more point drop on your APR – and all you need to do is call and ask.
3. Refinance your Mortgage… Eventually
Mortgage rates are correlated to the Fed rate, but are set taking other market factors into account as well. With the Fed rate decline, 30-year mortage rates have dropped to their lowest level since February of 2023. Is now a good time to refinance? With future Fed rate cuts coming, you may want to hold off on refinancing for a bit. Mortgage rates have fallen by at least 1.25% in every Fed rate-cutting cycle since 1971, most often declining over 2% or 3%.
Note that refinancing isn’t a free lunch – it comes with fees that are generally between 2-6% of the loan balance. As a general rule of thumb, many experts recommend waiting to refinance until rates are at least 1% below your rate. The large majority of mortgage holders, right now, have mortgages that are below 5%.
When should you refinance?
Start by calculating your refinance “break-even point”. This will be when your savings surpass the cost of refinancing. To calculate your break-even point on a refinance, take your refinancing costs and divide that by the monthly savings that a refinance would create. Your result will be the number of months that it takes to “break even”. In other words, how many months it takes for the refinance to pay for itself.
For example, if you have to pay $5,000 to refinance the mortgage and it saves you $250 per month, your break even will be 20 months ($5,000/$250 = 20).
If you plan to be at the home for longer than your break-even period, then a refinance could be worth doing. However, with future Fed rate cuts expected in the months ahead, your refinance savings could be higher and break-even period decreased in the near future. Of course, there are no guarantees when rates will change and by how much, so it’s a bit of a guessing game.