We all know that an economic downturn spells bad news for everyone, however, do you know how a recession really affects your interest rate on personal loans? The Federal Reserve is the main banking system in the US, and is charged with keeping prices stable, keeping interest rates moderate and maintaining a high employment rate. One way that it does this is by manipulating the federal funds rate, which is the rate that all banks charge other banks for loans. This rate directly impacts people’s own personal loan interest rates, and so this is why an economic downturn has an effect on people’s finances.
When Interest Rates are Cut
When the federal funds rate is lowered, peoples’ interest rates are also lowered. The Fed rate is altered in order to try to stabilize the economy during an economic downturn so that a balance is found between economic growth and low inflation. When interest rates are lowered, more money is made available to lend out which then trickles down to US consumers and thus stimulates the economy. This is why interest rates are generally cut during a recession.
The Effect of Low Rates
When rates are low this is great for US consumers who want to purchase a new home or a new vehicle, and so they are encouraged to borrow. However, if interest rates are made to be too low, it can then lead to excessive growth, and thus inflation. When inflation occurs it causes a decrease in peoples’ purchasing power, as well as unsustainable economic expansion. Low interest rates are also bad for savers, as it will cause them to save almost nothing on money market accounts, savings and checking accounts and short-term CDs.
When Interest Rates Increase
The Fed will increase the federal funds target rate in order to slow down inflation and put economic growth back on track to ensure sustainable rates. Interest rate increases also have a great impact on peoples’ wallets. Increased interest rates lead to finance goods being more expensive, such as cars or homes or paying off any type of debt. Increasing interest rates don’t always spell doom for consumers, as they are generally meant as a way to avoid hyperinflation and stabilize growth, and can even be a sign that the economy is on the upswing.
Effect of Increased Interest Rates
Interest rate increases tend to have a negative impact on consumers that live on a fixed income due to the fact that the resulting increased inflation has an affect on their standard of living because they aren’t able to increase their salary based on inflation rates. If rates become too high then financing can become unaffordable, which then results in a slowdown of the economy, and can even lead the economy into a contraction, which is an economic growth decline for two or more quarters. Rate increases are also good for those consumers who have liquid assets, such as money market, short-term CD and savings accounts that have a higher return yield.
While the Federal target rate is used for bank-to-bank lending, the prime rate is the rate that banks charge their consumers. Those consumers who are credit-worthy can then obtain prime rate financing, which is the lowest rate possible. However, the lower someone’s credit score is, the higher their rate will be. This is called the prime plus premium, and your income, assets, credit score and more affect it.
The Affect on Personal Loan Interest Rates
Those consumers who have fixed-rate personal loans will not see their interest rates affected by a downturned economy. However, those people who have variable rate loan will. The majority of personal loans are affected by the prime rate, and so a decrease in the federal funds rate caused by a downturned economy will lead to lower interest payments. Many U.S. households hold thousands of dollars in personal loan debt, and so a downturned economy will have a drastic affect on US consumers’ finances. Even for those consumers who have a fixed interest rate on their personal loan, companies are permitted to up the interest rate whenever they please as long as they give consumers an advance notice.