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Ups and Downs

by Kevin Ryan, CPA/Partner, Citrin Cooperman

Dec 13, 2019

PHOTO: © NUTHAWUT SOMSUK – DREAMSTIME.COM

December 2019

THE FEDERAL FUNDS RATE is the interest rate targeted by the Federal Reserve. It is the interest rate banks charge each other for overnight loans. After the recent cut on Oct. 30, 2019, the third cut this year, the rate will hover between 1.5 percent and 1.75 percent. The federal funds rate is not the rate used by banks for lending to individuals and businesses; that is the prime interest rate, currently at 4.75 percent. Since 1994 banks commonly calculate the prime interest rate as the federal funds rate plus 3 percent (in this case 1.75 percent plus 3 percent). Every U.S. bank sets its own prime rate; however, most utilize the same one.

The Federal Reserve changes the interest rate based on its feeling about the direction in which the economy is moving. The Federal Open Market Committee convenes about every six weeks and may also hold emergency meetings if monetary policy merits discussion between scheduled meetings. When economic data show the economy doing well, the Federal Reserve looks to keep the interest rate the same or perhaps raise it; the opposite occurs when the economy shows signs of weakness.

While lenders usually use the prime rate to calculate many loan interest rates, it is not mandatory for them to use this rate, nor is it a law. For instance, a mortgage interest rate is frequently lower than the prime rate because the mortgage is secured with real estate as collateral, which limits the bank’s downside if the loan goes bad. The customer’s credit history also plays a role in the bank’s interest rate decision.

The all-time high for the prime interest rate was 21.5 percent in 1980. Since 2017 the prime interest rate has hovered between 4 percent and 5.5 percent. The recent rate cuts signify the FOMC has concerns about the economy, as it has reduced the prime interest rate by 0.75 percent this year. Not every existing loan is affected by rate cuts, however. For example, for a loan with a balance of $500,000 with a variable interest rate based on the prime rate, it would cost $3,750 less per annum in interest charges due to the 0.75 percent lower interest rate. If someone has a fixed interest rate loan, the amount of interest would not change because the interest rate does not vary and would not be impacted by any rate cuts.

While it may seem like a good thing to have lower interest rates, it may signal a slowing economy and may negatively impact the value of investments, such as retirement plans or stock holdings.

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