How the Federal Reserve impacts your credit card interest rates
By Jeremy M. Simon | Published: November 27, 2006
You may notice that the interest rate on your credit card changes after the U.S. Federal Reserve makes one of its announcements regarding a change to the federal funds rate. In fact, most of the shorter-term interest that consumers pay are tied to the federal funds rate -- the target interest rate for overnight loans between banks.
It's called "federal funds" because banks are required by the Federal Reserve to have on hand a certain amount of money to back up deposits. The excess can be lended overnight to banks that need more cash on hand to meet their reserve requirements. The federal funds rate is labeled a "target" since actual rates paid are set by the market as banks lend money to each other, but the Federal Reserve adds or subtracts money from the banking system to push the real rate toward the target.
In November 2006, the fed funds target rate stands at 5.25 percent. However, in late October, the "effective" daily fed funds rate was reported to have varied between 5.23 percent and 5.26 percent, even as the target rate remained unchanged.
Banks use the fed funds rate as the benchmark to set their prime lending rate, which is the rate they charge their best customers. Generally, the prime rate is 3 percent higher than the fed funds rate, with the current prime rate at 8.25 percent. This difference, called the spread, happens because lenders are not willing to loan riskier consumers money unless they are paid more to take on that risk.
The amount of the spread is partially based on the borrower's creditworthiness and whether the loan is secured. An unsecured credit card loan has higher rates compared with a home equity loan, where a bank can repossess your house if you do not pay. With an unsecured loan, like borrowing with a credit card, if you have no money to give the lender, then they cannot get anything from you.
Should you have an excellent credit rating, you will likely get a credit card with a much lower interest rate than someone else who has a fair or poor credit rating.
Meanwhile, when borrowing money via mortgages and car loans, supply and demand factor in to your interest rates, with rates possibly declining when demand for something falls.
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