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Over the past few years, the Federal Reserve has aggressively raised its key interest rate to a 23-year high in an effort to tame inflation. Now, with inflation expected to slow significantly and moderate further, the central bank is expected to begin a campaign of interest rate cuts over the next two years, starting as early as September.
If that happens, it would lower interest rates on a wide range of financial products for Americans, from credit cards and mortgages to bank accounts and certificates of deposit.
Given that lower interest rates can affect your finances in a variety of ways, here are some things to consider when deciding what steps to take in response.
Timing and scale matter
The prospect of lower borrowing costs will be good news for those seeking loans or trying to reduce existing debt. But realistically, how much the Fed saves when it cuts interest rates will depend on how quickly it does so and by how much. In the short term, the answer is likely to be “not much.”
“Interest rates took the elevator up when they went up, but they will take the stairs down when they go down,” said Greg McBride, chief financial analyst at Bankrate.
What he means is that interest rates are not going to come down fast enough to get us out of a bad situation. [this year]”And for savers, [the initial declines] “Interest income isn't going to disappear. Savers are still in a good position.”
That's because one or two quarter-point cuts this year aren't going to cut much of your interest costs substantially, but a few cuts over the next year or two could make a noticeable difference, and it might be worth holding off on some moves until then.
“Don't jump into this too quickly,” says Chris Diodato, a fee-only certified financial planner and founder of WELLth Financial Planning.
Here are tips from Diodato and McBride on how lower interest rates will affect key areas of your financial life and what to do about it.
Taking out a mortgage is one of the largest financial transactions of most people's lives. Mortgage interest rates are influenced by a variety of economic factors, including the Federal Reserve's actions. Because loan amounts are large, even a small reduction in interest rates can make a big difference in the amount a homebuyer pays.
If you're buying a home this year, you might want to buy down points to lower your mortgage interest rate. Before you do, Diodato advises crunching some numbers to see if it will actually save you money if you consider refinancing in a year or two if rates drop further, since you could end up paying thousands of dollars now to get a lower mortgage rate and thousands more in fees to refinance later.
A 0.25-point buydown can cost 1% of the loan, while a 1-point buydown can cost 4%. Refinancing can be even more expensive, typically costing 2% to 6% of the loan, according to Lending Tree.
Noting that mortgage rates have fallen by at least 1.25 percentage points in every rate-cutting cycle since 1971, and often by 2 or 3 percentage points or more, Diodato observes: “Even if you lower rates by a quarter of a percentage point, or even a percentage point, there's still going to be people who want to refinance at some point in the next rate-cutting cycle. So my view is that you don't want people to have to pay both the points and the costs of refinancing.”
If you take out a home equity line of credit, keep in mind that it's no longer cheap money to borrow. The average interest rate on a home equity line of credit today is around 9% to 11%. McBride says they won't get significantly cheaper, even if the Fed cuts rates by a quarter of a percentage point a few times. “Americans have more assets than ever before, but they have to be careful about how they use that wealth because it costs a lot of money to borrow against it. Just because you have assets doesn't mean they're free money.”
Of course, if you take out a HELOC as an emergency lifeline and never use it, interest rates may not be something you have to worry about as much, but McBride noted that it could still cost you money through origination fees, if you're required to take out a minimum amount at closing, or other incidental costs to taking out a loan, like annual fees or dormancy fees.
And if you already have debt on a HELOC, “pay it off aggressively. This is high-cost debt that's not going to get cheaper anytime soon,” he suggested.
Another permanently costly debt is an outstanding credit card balance.sA few rate cuts are unlikely to have much of an impact on the current record-high average interest rate of 20.7%. Even if rate cuts ultimately bring the average rate down to the 16.3% it will be at in early 2022, it will still be an expensive loan.
So if you have credit card debt, the advice remains the same: If you qualify, apply for a zero-interest balance transfer card that gives you zero-interest credit for at least 12 to 18 months, effectively paying down the principal you owe.
If that's not possible, see if you can transfer your balance to a credit card from a credit union or local bank that offers lower interest rates than the big banks. “They usually offer fewer rewards, but your interest rate can be half as much,” says Dodiato.
If you're trying to finance a new car, lowering your interest rate might not be as helpful as you think: McBride points out that every 0.25 percentage point reduction reduces the typical loan on a $35,000 car by $4 per month, so a one percentage point reduction works out to just $16 per month, or less than $200 per year.
“The real determining factor for savings is the price of the car you choose, the loan amount and your credit rating,” he said.
When it comes to leasing cars, McBride noted that the Fed's rate cuts may have a similarly small impact on the so-called “interest rate factor” in lease payments, and that it's hard to gauge the impact of lower rates because what that factor is depends on so many variables.
The past year has been very good for people who parked their cash in online high-yield savings accounts, many of which offered yields above 5%. The same was true for people who parked their cash in certificates of deposit or Treasury bonds for a period of time, many of which offered yields above 5%.
Those rates will start to fall as the Fed starts to cut rates, but the initial declines are likely to be modest, meaning savings will likely earn returns above the rate of inflation for the time being, McBride predicts.
But going forward, it may no longer make sense to keep so much cash parked in these types of investment vehicles. “I would warn people not to fall into the cash trap. A lot of people who got used to these good savings rates were diverting money from stocks and long-term bonds,” Diodato said, predicting that savings rates will eventually fall to 3% over the next two years.
His advice: Don't hold more than six months to a year's worth of living expenses in cash or cash equivalents. “Anything more than that will negatively impact your future net worth,” he says.
But McBride suggests that if you're five years or less away from retirement, it might be worth locking in the higher interest rates still being offered to build up a cash pile to cover your living expenses in the first few years of retirement, so that a big market downturn early in retirement doesn't force you to pull funds from your long-term portfolio.
For example, many CDs with two-, three-, four- or five-year terms are currently paying yields between 4.85% and 5% on Schwab.com. If you choose a longer-term CD like this, be sure to look for one that isn't “callable.” A callable CD is one that the issuer can call out before the maturity date, which could happen if interest rates fall significantly in the next few years.
“The call feature is what the issuing bank says: 'Heads, I win; tails, you lose,'” McBride said.
