How the Federal Reserve affects credit card rates

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The Federal Reserve plays a crucial role in shaping the U.S. economy, including the interest rates you pay on your credit cards. As the Fed manages monetary policies and sets interest rates to control inflation, your wallet feels the impact.

In a recent move, the Fed has lowered interest rates by 50 basis points, or half a percentage point. This is good news for credit card holders — when the Fed lowers rates, credit card rates tend to follow suit. While this change will likely impact your cards soon, you don't have to wait to take action. You can prepare by understanding your credit score and shopping around for better card offers.

What is the Federal Reserve?

Congress founded the Federal Reserve in 1913 to address worries about financial crises that caused banks to close and led to economic recessions in the 1800s. Over the years, its role in banking and the economy has expanded.

Think of the Federal Reserve as a puppet master of the U.S. economy. The Fed's job is to keep our financial system in harmony. The Fed focuses on five main objectives:

• Conducting monetary policy to encourage employment, maintain stable prices, and ensure moderate long-term interest rates.
• Promoting stability in the financial system and reduce systemic risks.
• Regulating the safety and soundness of financial institutions while monitoring their effects on the economic system.
• Supporting the safety and efficiency of payment and settlement systems.
• Fostering consumer protection.

A couple of the key tools used by the Fed include:

• Open market operations: Buying and selling securities to influence interest rates.
• Discount window: Provides depository institutions with access to funding from Federal Reserve Banks.
• Reserve requirements: Mandating how much cash banks must keep on hand.

The Federal funds rate

The federal funds rate is the Fed's “secret sauce” for influencing the economy. It's the benchmark rate banks use when lending money to each other. In other words, a bank with excess cash will lend to another bank that needs to raise liquidity quickly.

The Federal Open Market Committee (FOMC) meets eight times yearly to set this target rate, using the country's economic health as its guide.

Here's how it works: When the Fed wants to cool down a hot economy, it raises the rate. When it wants to boost the economy, it lowers the rate. The Fed uses a mix of buying and selling government bonds to hit its target rate.

How the federal funds rate impacts your credit card rate

While the Fed doesn't directly set your credit card's interest rate, it plays a crucial role. Here's the chain reaction:

1. The Fed sets the federal funds rate.
2. The federal funds rate influences the prime rate.
3. Credit card issuers typically set their rates above the prime rate.

Eric Kelley, chief investment officer at UMB Bank, explains further: "The prime rate is the interest rate banks charge their most creditworthy customers for loans and products. It is the best rate available for the best borrowers, typically 3.00% above the Fed Funds rate." 

Most issuers charge a rate above the prime rate because credit card borrowers are less creditworthy than prime business borrowers, Kelley says.

For example, if you have a good FICO score (typically between 670 and 739), you might expect a credit card annual percentage rate (APR) several percentage points above the current prime rate.

The exact spread can vary based on market conditions and the specific card, but it's common to see rates around 5 to 10 percentage points above prime for borrowers in this credit score range.

Fixed vs. variable APR

Credit cards come with fixed or variable APRs. The names pretty much spell it out: a fixed APR doesn't change, while a variable APR changes with the index interest rate. If you have a variable rate APR, the bank can change your rate when the index changes. If you have a fixed APR, the bank can still change your rate, but there are limits, and they must notify you.

Most credit cards come with variable APRs, meaning your rate can change when the index rate changes. Fixed-rate cards are rare in the credit card world. Kelley notes, "It is easier for the credit card companies to manage their interest rate risk by issuing variable rate debt to consumers."

While banks can't change rates in your first year of card ownership, they can adjust them later with 45 days' notice. There are exceptions, such as introductory rates or if you're more than 60 days late on a payment.

What Fed rate changes mean for your wallet

When the Fed adjusts rates, your credit card bills feel it. Adrianna Adams, certified financial planner and head of financial planning at Domain Money, explains: "As the Fed changes the fed funds rate, the interest rates you see for new mortgages or car loans, current credit cards or home equity lines of credit, etc., will change as well."

The Fed has recently cut rates by half a percentage point, bringing the federal funds rate to a new target range of 4.75-5%. This move should lead to lower credit card balances and potentially make new offers more appealing and affordable. Experts anticipate further rate cuts in the coming months if economic conditions continue to improve.

Here's what to expect:

• Rate increases: Higher minimum payments and interest charges
• Rate decreases: Lower payments and potentially better offers on new cards

But don't expect miracles overnight — a small Fed rate cut won't dramatically slash your credit card's APR.

Smart strategies for credit card users

No matter what the Fed does, here are some savvy moves to consider:

1. Avoid carrying a balance if possible: Adams strongly advises against carrying credit card balances: "Credit cards often carry interest rates that are significantly higher than other borrowing options (sometimes over 20% even when rates are 'low'). It can be very difficult to dig yourself out of debt if you keep accumulating high interest costs."
2. Pay down debt aggressively in a rising rate environment: When rates are climbing, focus on reducing your credit card debt as quickly as possible to minimize the impact of higher interest charges on your balance.
3. Consider refinancing or balance transfers when rates fall: When rates fall, look into refinancing or transferring balances to lower-rate cards. This strategy can help you take advantage of more favorable rates and potentially save money.
4. Understand your credit card agreement: Always read the fine print in your credit card agreement. This will help you understand how the issuer sets rates and what fees may apply.
5. Shop around for better rates and terms: Don't settle for your current card's rates. Keep an eye out for better offers, especially when the Fed changes rates, as new offers may become more attractive.
6. Keep an eye on balance transfer offers: Balance transfer credit cards can be a useful tool for managing credit card debt. However, be aware that Fed changes can influence these offers.
7. Improve your credit score: A higher credit score can help you qualify for better rates and terms. Focus on paying your bills on time, keeping credit utilization low, and avoiding applying for too many new credit lines at once.
8. Use rewards wisely: If you use credit cards, maximize your rewards, but remember: they're only valuable if you're not carrying a balance. High interest charges can quickly outweigh any perks.
9. Consider a fixed-rate personal loan: A fixed-rate personal loan might offer a lower interest rate and a structured repayment plan if you're struggling with high-interest credit card debt.
10. Stay informed about Fed decisions: The Fed meets eight times yearly to discuss rate changes. Mark these dates on your calendar and stay informed about potential impacts on your credit card rates.

Frequently asked questions

The bottom line

Your credit card rates and the Fed's policies are like dance partners — when one moves, the other follows. Stay informed about the Fed's decisions, which happen eight times a year, and be ready to pounce on better card opportunities when they arise.

Whether rates are rising or falling, the key is to manage your credit responsibly, pay off balances when possible, and watch for better deals. By staying informed and proactive, you can navigate changing interest rates and keep your credit card costs in check.

Editorial disclosure: Opinions expressed are author's alone, not those of any bank, credit card issuer, or other entity. This content has not been reviewed, approved, or otherwise endorsed by any of the entities included in the post.