What Do the Federal Funds Rate Cuts Mean to You? Unless you were in some other country, you have to know that the Federal Reserve cut the federal funds rate by half a point at their most recent meeting. How will this cut affect you? As usual, the answer will depend on your financial goals and where you stand in your quest for financial independence.
Looking for a New Fixed Rate Mortgage? As I've said dozens of times, the Fed only controls short term rates. Long term rates can go up or down with a Fed rate cut depending on whether or not the market perceives the cut as inflationary. The immediate result of the rate cut was that long-term fixed rates increased slightly because of fears that the additional liquidity might help perpetuate some of the excesses of the past as consumers continued to borrow to buy stuff they really didn't need. Don't expect these rate cuts to help you get a lower fixed-rate mortgage.
Will The Cut Make Your ARM Loan More Manageable? Several financial columnists have written that these rate cuts won't help lower the foreclosure rate. The fact is they might make a difference in some cases. ARM loans usually adjust based on some margin over the one-year treasury. This is a short-term index and should drop when the Fed cuts rates. The standard one year ARM adjusts at 2.5-2.75% over the index. This means that your next adjustment should leave you in the 6.5 to 7% range. Hardly a disaster. If you have one of the sub-prime ARMs, the margin can be as much as double that. Even though your adjustment may be a half point lower than before the cut, the margin is so large that it will still cause a major trauma to most borrowers.
Got a Home Equity Line of Credit? Most of these are based on the prime rate which should decrease dollar for dollar with a Fed cut. If your loan was at prime, or 8.25%, it will drop to 7.75%. This means that a borrower with a $100,000 loan should see a payment reduction of about $500 per year. Funny, how it seems that many borrowers hardly notice a reduction of that magnitude but scream like they were shot when rates increase that much.
Going to Open a Savings Account or Buy a CD? In general, you will find it difficult to locate decent rates on your cash accounts. Banks will quickly lower what they are willing to pay for funds after a Fed rate cut. This is at a time when the average rate on bank money funds is less than 1% and demand savings accounts often pay 1-2%. If you shop diligently and are willing to do business at a bank not necessarily located in your town, you will be able to beat these averages but even aggressive banks will gradually lower rates on funds they have on deposit. Brokerage money accounts will also pay lower rates as a result of the Fed cut and we need to remember that these funds are not insured like bank funds. Although no one has ever lost money in these funds, its not impossible, particularly when we have a credit crunch like the one we recently experienced.
Looking to Buy Stocks? The effect of the Fed cut on the market was immediate with the Dow rising more than three hundred points the day of the cut. At this point, the market is near an all time high as the cost of leverage decreased and liquidity levels increased. Good news for those who are in the market? Remember my recent post about liquidity breeding stupidity. Lower rates encourage bad behavior as consumers borrow to buy items they don't really need, home buyers are willing to bid up the price of homes because monthly payments are low, and investors chase higher yields with little regard for risk. Now is the time for conservative investing. One opportunity appears to be high-dividend stocks which have taken a disproportionate hit in the recent correction. This will require considerable due-diligence since some stocks dropped for a reason. High dividends are never attained without risk. A portfolio of high dividend stocks must be carefully managed to avoid those stocks where the risk outweighs the return.
Is The Recent Cut Good or Bad? While investors obviously thought the cut was good, I question the wisdom of adding more of what caused the problem in the first place. Cheap money isn't always cheap in the long run. The strongest advice that I can give anyone is to borrow only when necessary. It's not a bad time to reduce your overall debt level. Be careful not to over spend your income. Another severe correction is not out of the question.
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