To help the U.S. economy regain some of the footing it lost in 2000, the U.S. Federal Reserve has been guiding the nation's banks toward lower interest rates. This news is of great interest to consumers who are about to buy a house or a car and may now pay lower interest rates. But in addition to affecting your cost of financing, lower rates also affect your investments and your existing loans. Here's how.
If You Need to Borrow Money
When the Fed lowers rates, it is really lowering the prime rate, which is the rate at which banks lend money to each other. That in turn affects the rate at which banks and other lenders will lend money to you, so the rates on your new auto loans, mortgage or credit cards could decline. But what if you have existing loans?
Lower rates can allow you to refinance existing loans at a lower rate. Sometimes this is as easy as calling your credit card company and asking to have your rate lowered. If your account is in good standing, your credit card provider just might agree.
You can also contact lenders such as LendingTree or E-Loan to see if you can refinance existing auto or home loans. These online companies have access to dozens of lenders who will look at your existing loan and determine whether they can offer you a better rate. Be careful, however, to make sure you're actually lowering your interest rate. Don't fall for a refinancing plan that only lowers your payments by extending the loan term at a similar or higher rate -- you could actually end up paying more in the long run unless you refinance at a lower rate.
If You Plan to Invest in Money Markets or CDs
The other side of lower rates applies to investments in regular savings accounts, money market accounts and certificates of deposit (CDs). When the Fed lowers rates it puts downward pressure on interest rates offered by banks, meaning they're not willing to pay you as much to invest money with them.
Staying informed about whether the Fed might be about to further lower rates can work to your advantage if you're planning to invest in a CD anyway. You can seek out good rates and lock them in before the Fed makes its next expected move to lower rates. For example, if a bank is offering a particularly enticing six-month CD rate, you might want to jump now, anticipating that the same bank will offer a lower interest rate in the coming weeks on the same six-month account. Check BankRate.com for a comparison of rates offered by different banks on different accounts.
For basic savings accounts and money markets, however, there's no such thing as locking in rates. If the Fed lowers rates, your money market account might offer 4.5 percent interest rather than the present 5 percent. That means you'll be earning less. At this point you may decide that you're less interested in savings or money market accounts, and you may want to move your money to other financial instruments.
What about stocks and bonds?
The general rule of thumb is that when interest rates fall, stock prices and bond prices generally go up. This is because demand for them increases as people start switching their money into them and away from savings accounts. This is good news if you already have stocks, because potentially they'll go up in price.
If you're considering investing in stocks or in stock mutual funds, knowing that interest rates may be on a downward trend might make you predict that stock prices will rise, making stocks and stock mutual funds a more enticing investment now.
Prices for existing bonds also rise as interest rates fall. This is because these bonds were issued at higher interest rates, which now look attractive compared with the lower interest rates brought about by the Fed's decision to lower its benchmark rate. So even though bond prices rise when rates drop you may want to consider buying them because they pay a guaranteed rate of return -- or yield -- that may be higher than money market accounts and newer bonds that will be issued at the lower rates. If you own bonds, you can also take advantage of the higher prices. In other words, if you want to sell your bonds, now's the time.
Do I have to do anything?
Remember, however, that just because interest rates are changing, it doesn't mean you have to re-evaluate all your loans and investments and make wholesale changes in your finances. It just means you should keep an eye on trends in interest rates and make smart decisions.
The more you know about interest-rate movements, the better you can understand your financial picture. And when you're ready to make a move, you'll be able to make the right one.