Breaking down the interest rate cut: How it may affect you

Wednesday, October 8, 2008 | 10:36 p.m. CDT; updated 11:10 a.m. CST, Wednesday, February 11, 2009

The Federal Reserve's cut in its benchmark interest rate Wednesday could put more money in your pocket — or take some out. Or both. Figuring out exactly how you're affected may be more complicated than usual, so here are some questions and answers:

Q: Will I earn less on my bank savings?

A: If you have money in interest-earning bank accounts or certificates of deposit, you can expect to be "as disappointed as Cubs fans," said Greg McBride of rate tracker in North Palm Beach, Fla. "They're continuing to take it on the chin every time the Fed cuts rates."

Bank depositors have benefited lately from intense competition for their money,  because the credit crunch has made it difficult for banks to get funds elsewhere. That competition remains "spirited," but the Fed's action probably will result in lower rates, agreed Keith Gumbinger, vice president of rate tracker HSH Associates in Pompton Plains, N.J.

"Instead of promoting an 18-month CD at 4 percent, they may compete only at 3.5 percent," Gumbinger said.

Q: I heard the prime rate went down to match the Fed cut. How will that affect my loans?

A: After the Fed lowered its benchmark rate by half a percentage point, to 1.5 percent, most banks followed as usual by dropping their prime rate by the same amount, to 4.5 percent from 5 percent. That could mean an instant rate reduction for many borrowers with credit-card debt or a home-equity line of credit tied to a bank's prime rate.

Unfortunately, some credit-card holders will see no benefit because of interest-rate floors built into their card agreements, McBride said. A card that charges the prime rate plus 6 percentage points might have a floor of 11 percent, for example, keeping it from dropping to the 10.5 percent level it otherwise would have reached with the Fed cut.

Q: Will I save money on my adjustable-rate first mortgage?

A: These mortgages typically fluctuate based on something other than the prime rate, and the two most popular indexes used to calculate these rates have behaved strangely in recent weeks and months because of the credit crisis.

The yield on one-year Treasury securities is used to calculate about one-third of adjustable-rate mortgages, while Libor rates — what banks charge other banks for loans — are used on about half.

As panicked investors recently moved money into short-term Treasuries, the yield on the one-year Treasury bill tumbled to 1.18 percent Tuesday from above 2 percent in early September. After the Fed rate cut, the yield rebounded to 1.24 percent. It's hard to say where the yield will go.

Conversely, Libor rates have been much higher than normal, and the Fed rate cut may not help that much. That's bad news for holders of subprime mortgages, which typically have a fixed rate for two or three years and then begin adjusting every six months based on the six-month Libor rate.

"You may have dodged the bullet on your initial rate reset six months ago only to get blindsided by a big payment increase this time around," McBride said.

Q: What about fixed-rate mortgages?

A: If you have a fixed-rate mortgage, nothing will change — that's what fixed rate means. For new mortgages, 30-year fixed-rate loans generally track the 10-year Treasury note, which does not respond to the Fed's short-term rate as much as it does to expectations about inflation and the health of the economy and credit markets.

The yield on the 10-year Treasury has been volatile of late, rising about one-quarter of a percentage point Wednesday, but has remained low enough recently to keep rates for traditional mortgages in the low 6 percent range — a good deal by historical standards, Gumbinger said.

Q: What about money-market funds?

A: For taxable money-market funds, "You could do better putting your money into a top yielding bank savings account or money market deposit account," McBride said. "The top-yielding bank accounts are north of 3.5 percent, and even if they come down they will be significantly higher than taxable money funds."

Tax-free money-market funds are posting higher returns as the credit crunch forces municipalities to borrow short term at higher rates. "But that is neither permanent nor without risk," McBride said.

Q: Will it be easier to get a mortgage now?

A: Perhaps — if you have a solid down payment, can document your income and qualify for a plain-vanilla loan. But keep in mind that fixed rates do not track short-term Fed rates and that you'll still have to pay dearly for anything other than traditional loans that Freddie Mac and Fannie Mae can buy or guarantee.

One example: Jumbo mortgages — loans too big for Fannie and Freddie — now start at $730,000 in pricey areas of California, and borrowers who take on jumbo loans must pay interest rates of 7 percent or above.

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