The federal reserve and interest rates
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The federal reserve and interest rates

The central banking system of the U.S. ...

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The Federal Reserve, often referred to as the "Fed," is the central banking system of the U.S. It is made up of a Board of Directors, regional Federal Banks, and other entities. The Chairman of the Board (formerly Alan Greenspan), is the public face of the Fed and often the blunt of criticism. But what is the purpose of the Federal Reserve and how does it affect individual consumers?

The Federal Reserve was established in 1914 with a goal of providing strength and flexibility to the U.S. financial system. It's direct responsibilities are to:

  • Regulate banking policies
  • Control the amount of currency in circulation
  • Set the target federal fund rate (the rate at which banks can borrow from each other)

While each responsibility of the Fed is important to a strong economy, the changing of the fund rate has the most impact on short-term rates. The raising or lowering of this rate often affects interest rates on mortgages, credit cards, and home equity lines of credit. When the target rate is raised, consumers pay more interest. When the rate is lowered, they pay less.

As a homeowner or potential buyer, the actions of the Fed can have a direct impact on your financing options. Adjustable rate mortgages (ARM's), which have been popular in recent years, have left a vast number of homeowners subject to the whims of the Fed. ARM's have a fixed interest rate for "x" amount of years, but after this period they can fluctuate based on short-term indexes. When the Fed raises the target federal fund rate, it ripples through the short-term indexes. This means individual consumers end up paying more per month on their mortgage.

Home equity lines of credit (HELOC's) are closely tied to the prime rate and actions of the Federal Reserve. 17 consecutive rate hikes have caused the prime rate to double since 2004. Variable rate HELOC's will continue to affect existing and potential buyers. It is important to understand the correlation between actions of the Federal Reserve and the monthly payments on your mortgage or line of credit.

Rate hikes will also affect credit cards. Credit card interest rates are tied to the prime rate, which is susceptible to the actions of the Fed. Rate increases tend to move slowly to credit cards because issuers reprice cards once a quarter. This means you may not see the rate increase immediately, but in the future your credit card's interest rate could jump.

So how does one guard against the effects of the Fed? Switching from an ARM to a fixed rate mortgage can shelter you from the rate hikes. Fixed rate mortgages are tied closely to government bonds - which are not susceptible to short-term rate increases by the Fed. Fixed mortgages are based on long-term economic indicators and can withstand actions taken by the Federal Reserve. Refinancing an ARM has become popular in recent months due to the security and peace of mind offered by a fixed rate mortgage.

HELOC's offer flexibility for acquiring the credit and repaying the debt. However, short-term rate increases can increase the interest payments and affect the principle. The key to understanding HELOC's is judging your ability to handle varying payments. This involves weighing the advantages of flexibility against the possibility of higher payments.

Credit card debt is a common problem in America. However, there are strategies which can help consumers deal with the debt. Transferring balances from high interest cards to lower rate cards can help. Many credit card companies offer promotional balance transfers which can be used to your benefit.

The key to dealing with actions of the Fed is understanding. Actions taken by the Federal Reserve can directly affect your monthly expenses. It is important to consider all options in regards to mortgages, lines of credit, and credit cards. An experienced mortgage consultant can assist you in modifying your mortgage, learning about lines of credit, and consolidating debt. The Fed will continue to play an integral role in guiding the economy. However, consumers have choices when it comes to their finances. (don)
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