What to do when the Fed starts lowering interest rates

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CNN
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Over the past two years, the Federal Reserve has aggressively raised its benchmark interest rate to its highest level in 23 years to combat inflation. Now that inflation has slowed down considerably and is expected to calm down further, the central bank is expected to embark on a rate reduction campaign over the next two years, starting in September.

If so, rates are likely to fall on a wide range of financial products aimed at Americans, from credit cards and home loans to bank accounts and certificates of deposit, among others.

Given the many ways that falling rates can affect your finances, here are some things to consider when deciding what actions to take in response.

Timing and scale matter

The prospect of lower borrowing costs will be good news for those looking for loans or anyone trying to reduce their current debt. But realistically, how much you save when the Fed cuts rates will depend on how quickly it cuts them and by how much each time. The short-term answer is probably “not so much.”

“Interest rates took the elevator up, but they’ll take the stairs down,” said Greg McBride, chief financial analyst at Bankrate.

What he means is, “Rates aren’t going to come down fast enough to get you out of a bad situation (this year),” McBride said. “And for savers, (the initial cuts) won’t wipe out your interest income. Savers will always be one step ahead.”

Indeed, one or even two quarter-point rate cuts this year won’t significantly reduce much of your interest costs. But several cuts over the next couple of years could make a noticeable difference, and it might be worth holding your fire on some moves until then.

“Don’t rush into this stuff too early,” said Chris Diodato, a fee-only certified financial planner and founder of WELLth Financial Planning.

Here’s a look at how falling rates can affect key areas of your financial life, plus advice from Diodato and McBride on what to do next.

Getting a mortgage is one of the most important financial moves most people make. Mortgage rates are influenced by a number of economic factors, and the Fed’s actions are one of them. Since loan amounts are large, this is an area where even small reductions in interest rates could make a significant difference to what a buyer will pay.

For those buying a home this year, you may be tempted to purchase points to lower your mortgage rate. Before doing so, Diodato advised doing some math to make sure it will actually save you money if you think you might be tempted to refinance in a year or two if rates fall further. That’s because you’ll pay thousands of dollars to lower your mortgage rate now, and then thousands more in refinancing fees.

Redeeming a quarter point could cost you 1% of your loan or 4% for a full point, he said. To refinance, the costs could be higher — they’re typically between 2% and 6% of your loan, according to Lending Tree.

Given that mortgage rates have fallen at least 1.25% in every rate cut cycle since 1971, and often by more than 2% or 3%, Diodato sees it this way: “Buying your rate down a quarter of a percentage point, or even a full percentage point, wouldn’t stop most people from wanting to refinance at some point during the next rate cut cycle. My So the reasoning is not to impose on people both the payment of points and then the costs of refinancing.

As for taking out a home equity line of credit, know that it’s no longer cheap money to borrow: the current average rate range for HELOCs is about 9% to 11%. A few quarter-point rate cuts from the Fed won’t make the Fed significantly cheaper, McBride said. “Americans have more equity than ever, but you have to be judicious in how you leverage it, given the cost of borrowing. Just because you have equity doesn’t mean you’re getting free money.”

Of course, if you simply take out a HELOC to serve as an emergency lifeline and never tap it, the rate may be less of a concern. But it can still cost you money in closing costs, any requirements that you withdraw a minimum amount at closing, or any other incidental fees related to the line, like an annual fee or inactivity fee, McBride noted.

And if you already owe money on a HELOC, he suggested, “pay it off aggressively. It’s a very expensive debt that’s not going to get any cheaper anytime soon.”

Another form of perpetually costly debt is your outstanding credit card balance.s. A few rate cuts won’t do much to change the current record average rate of 20.7%. Even if the rate cuts eventually return the average to its level at the start of 2022 – 16.3% – this will still be an expensive loan.

That’s why, if you have credit card debt, the advice is the same as it’s always been: If you qualify, sign up for a zero-interest balance transfer card that can get you at least 12 to 18 months interest-free so you can significantly pay down the principal you owe.

If this proves difficult to obtain, see if you can transfer your balance to a credit card from a local credit union or bank that offers lower rates than larger banks. “They usually have fewer benefits, but their rates can be half as much,” Dodiato said.

If you’re looking to finance the purchase of a new car, a rate reduction environment might not help you as much as you think. McBride notes that each quarter point reduction reduces a typical $35,000 car loan by $4 per month. So a total drop of one percentage point equates to just $16 per month, or less than $200 per year.

“Your real savings lever is the price of the car you choose, the amount you finance and your credit score,” he said.

When it comes to leasing a car, McBride noted, the effect of a Fed rate cut could be just as small on what’s known as the “money factor” you’ll pay for the lease, and because many variables determine what that factor will be, it will be difficult to understand the impact of an interest rate cut.

The past year has been a very good one for everyone who put money into high-yielding online savings accounts, many of whom paid rates above 5%. The same goes for those who could lock up their money for certain periods in certificates of deposit or Treasury bills, many of whose terms also paid north of 5%.

Although these rates will start to fall when the Fed begins cutting rates, the cuts probably won’t be huge at first — meaning you could still earn more on your savings than the rate of inflation for a while, McBride predicts.

But it may no longer make sense to leave so much cash in these types of vehicles in the future. “I warn people about the cash trap. A lot of people, accustomed to these attractive savings rates, were diverting their money from stocks and long-term bonds,” said Diodato, who predicts that savings returns will eventually fall to 3% in the next two years.

His advice: don’t keep more than six months to a year’s worth of living expenses in cash or equivalent. “Beyond that, you’re putting a damper on your future net worth,” he said.

That said, McBride suggested that if you’re less than five years from retirement, you may want to take advantage of high rates still offered today to increase the money you’ll need to cover living expenses in the first few years after you stop working. Having this cash on hand means you won’t be forced to withdraw from your long-term portfolio in the event of a sharp rise. market slowdown at the start of your retirement.

For example, many CDs with terms of two, three, four, or five years currently pay between 4.85% and 5% on Schwab.com. If you’re going for a longer-term CD, try to find one that isn’t “callable.” A callable CD is one that the issuer can choose to close before its maturity date, which could happen if rates fall significantly in the next few years.

“The calling feature is a ‘Heads I win, tails you lose’ for the issuing bank,” McBride said.