The U.S. Federal Reserve on Wednesday reduced its benchmark rate for the third time this year, to a range of 1.5% to 1.75%.
What does the rate cut mean for Americans’ financial wellness? Two members of the American Institute of CPA’s financial literacy commission shared their thoughts.
Neal Stern said the rate cut has implications in several key areas. One is the interest rate people pay on credit cards.
“If you’re paying off a credit card balance, check your statement to see if your card has a variable interest rate, which is likely to decline in response to a Fed rate cut,” Stern said in a commentary.
Lower interest charges can enable the cardholder to pay off the balance faster just by maintaining the same payment as before, since more of the payment will reduce the amount owed.
Stern said now may be a good time to shop around for lower rates, as card issuers can compete for business by passing along the lower rates in balance transfer and other offers. “Be sure to understand the terms and any fees involved.”
Another area in which rate cuts have a notable effect is mortgages and home equity loans, the payments on which may decline.
“That’s a great opportunity to use the savings to increase your 401(k) contribution at work, especially if you’re not already taking full advantage of your employer’s matching,” Stern said.
For those who expect to remain in their home for several years, it may be worthwhile to consider conversion to a fixed rate mortgage, he said. True, interest rates may initially be higher, but the certainty of stable payments without concern about future rate changes can help the homeowner manage a budget and work toward long-term goals.
The interest rate cut can also affect savers. “If your bank lowers the interest rate on your savings account, it pays to shop around, including a look at online banks and credit unions that compete for your funds,” Stern said.
He also suggested investing some of the money — over the amount set aside for emergencies — in a “ladder” arrangement, such as CDs that mature in 6, 12, 18 and 24 months.
Doing this may result in higher rates than standard savings accounts yield, and help protect earnings from future rate cuts, he said. “Be aware of any penalties that may apply if you need to withdraw money before the maturity dates.”
Stern noted that the Fed uses rate changes both to help manage the risks of inflation and as a tool to support the health of the economy. “While we haven’t seen rampant inflation-driven general price level increases in recent years, we’re not immune to escalation that can quickly erode the purchasing power of your savings for retirement and other goals and boost your interest payments on what you owe.”
He said one can manage this risk to financial wellness by paying down variable rate borrowings and maintaining a balance of investments consistent with one’s comfort level, which include assets such as common stocks or mutual funds that can reflect price level changes.
“A qualified financial advisor can help you develop a long-term plan that fits your situation,” he said.
Good News, Bad News
“The rates on any variable debt tied to short-term rates such as the bank prime rate, the T-Bill rate, Libor rates and CD rates will likely be going down,” Monica Sonnier said. “Values may also rise on some fixed income investments such as bonds and mutual funds that hold bonds.”
Credit card companies have the opportunity to lower interest rates, but that usually happens slowly as card companies are reluctant to lower their margins quickly, Sonnier said.
Sonnier noted that many people think that the Fed controls all interest rates, but in fact it controls only the federal funds rate and the rate it charges other banks to borrow from the Fed. The Fed funds rate is the central bank’s main tool to influence other short-term rates.
This means that short-term rates that influence the rates that savers and investors receive on savings accounts, money market accounts, CDs, T-Bills and floating-rate bonds will probably decrease in lock step with the fed funds rate.
Although this will hurt retirees who rely on income from short-term instruments, Sonnier said, it will likely not have a major effect on longer-term interest rates that affect fixed income investors in most bond portfolios, mutual funds and ETFs.
Why? The lowering of short-term rates is expected to create a return to a more traditional upward sloping yield curve with short-term rates falling, but longer-term rates remaining mostly unchanged.
“The longer-term rates reflect the outlook of the markets that growth in the economy is likely to stall or fall slightly in the one- to five-year horizon,” she said.
Sonnier noted that the rate cut would pinch savers and retirees, lowering rates they receive on savings accounts, money market accounts and CDs. In addition, banks will likely see a decline in earnings and their stock prices as their margins narrow with declining rates.
Even as short-term rates go lower, longer-term rates are probably anchored to a tight range for the foreseeable future, meaning mortgage rates are unlikely to fall much, Sonnier said.
“This will not help potential homebuyers to afford homes in today’s tight market,” she said. “High home prices and limited inventory, not mortgage rates, are more to blame for homebuyers’ difficulties in purchasing homes.”
Moreover, if the Fed’s rate cuts contribute to a continuation of the economic expansion, those conditions are likely to get even worse, she said.
But those ready to buy a home now do not need to rush to lock in rates as they are not likely to rise anytime soon, according to Sonnier. Indeed, it could be more advantageous to have another look at adjustable-rate mortgages, which have been out of favor for some time.
“A mortgage with an initial fixed period followed by an adjustable period, like a 5/1 ARM, will typically have a very low initial or ‘teaser rate,’ which then converts to an adjustable rate setting off of a short-term index like the T-Bill rate,” she said.
“These can be a good alternative as long as you manage the risk of the rate conversion by carefully planning to convert to a fixed-rate mortgage at some time before rates start rising again or if you plan on only being in the home less than five years anyway.”
In the near term, falling rates definitely favor the borrower over the investor, Sonnier said. Borrowers may find good opportunities to refinance older debt at higher rates or lock in fixed rate financing to roll over older adjustable-rate debt, including student loan debt.
For fixed income investors, short-term rates are still a relatively attractive parking place until the longer-term rates return to a more normal level — though that could be years ahead.
“Although investors have been pouring billions of dollars each week into bond funds and fixed income investments, history generally shows that falling rates are a good thing for the stock market,” she said. “The stock markets generally have double-digit gains in the early years of an easing cycle by the Fed.”
— Check out 10 Scariest Retirement Statistics: 2019 on ThinkAdvisor.