Friday, October 10, 2008

How the Federal Reserve Impacts Your Credit Card Interest Rates

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 high credit-worthy banks.

The U.S. central bank establishes the target rate during the Federal Open Market Committee's eight regularly scheduled annual meetings. The rate is labeled a "target" since actual rates paid are set by the market.

In November 2006, the Fed Funds target rate stands at 5.25%. However, in late October, the "effective" daily Fed Funds rate was reported to have varied between 5.23% and 5.26%, 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% higher than the Fed Funds rate, with the current prime rate at 8.25%. 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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