What the 1% Fed Funds Rate Means to You, Your Neighbors, and Your Neighborhood Bank

First let me say that I've got good news for you: If you're reading this blog, you're probably not going to be as affected by the troubles of today's economy as someone not reading my blog. Many of my readers are young 20 or 30-somethings that navigated here from Facebook or Twitter (yes, I keep track of my demographics!). Unfortunately for me (and them), I don't have a lot of older, fixed-income Americans reading my site. And they're the ones that are going to suffer the most in our troubled financial environment.

Yesterday the Fed cut its Funds Rate to 1% -- the lowest it's been since 2003. And the last time it was at 1% prior to 2003 was in about 1960. One might say that, historically, it's an uncommonly low rate. But what does it mean? Why is it so low? Should you be concerned? And who should really be concerned?

What it means:
You may be under the impression that when you go to the bank and ask for a mortgage, the amount the bank can give you is limited to the amount of deposits that it has from your neighbors. If you want to borrow $100,000 for a house, your rich old fogey neighbors down the street need to have at least that much sitting in their CD or savings account if you want the money...right? ...right?!?

Wrong.

Actually, if you want to borrow $100k from the bank, your rich old fogey neighbors only need to have $10,000 in their account. That's because banking regulations say that banks are only required to have 10% of their outstanding loans in reserves, a.k.a. "cash in the bank."

The Fed is the nation's central bank, and has kind of a big brother/little brother relationship with smaller, commercial banks. Commercial banks, eager to make bank (forgive the expression), lend out as much money as they possibly can every day because lending money is how they make money. But at the end of the day, when the little brother sees that he's lent out$150,000 and only has $10,000 in cash reserves, he knows that he's broken the rules (he only has 6.6% reserves, not the required 10%)...and he had better have that 10% before close-of-business (a.k.a "when dad gets home"). So what does he do? He goes to his big brother (the Fed) and asks, "Hey bro, can you spot me five grand before dad gets home? I promise I'll pay you back tomorrow...and with interest!" Big brother lends him the five grand, and the next day, as promised, little brother pays him back with interest equal to the Fed Funds Rate.

Because commercial banks are in the interest of maximizing their profits, they lend out as much as they can every day. But they never really know for sure how much cash they'll have at the end of a given day, so there's no way to know for sure how much they can loan out on a given day. If they lend too much (more than nine times their deposits), they'll need to borrow money from the Fed. But if little brother knows that he can borrow money from his big brother overnight at a mere 1%, he won't be as afraid to lending out more than he's allowed.

Why it's so low:
Big brother knows that loans are important to his little brother and all of the people that he lends to. And big brother helps out wherever he can. Well, the big problem as of late is this: the little brother lent lots of money to subprime borrowers, many of whom never paid him back. So all of the sudden, the cash reserves of his little brother diminished. Now, instead of using his cash in the bank as a reserve for making more loans, he is using that cash to cover his costs associated with foreclosures. And because more and more people aren't making their mortgage payments, he has less and less money that he can use as reserves for new loans.

Think of it this way: if a foreclosure costs a lender $70,000 (which is realistic), it means that lender will have to decline $700,000 in new loans. That means that one foreclosure might prevent three or four qualified people from getting a mortgage.

Many of the little brother's customers -- even those with good credit -- can't get new loans. It isn't anything personal -- he just can't afford to lend to them! These customers are both businesses and individuals. And when businesses can't get the loans they need, it sometimes leads to layoffs, which in turn leads to more individuals defaulting on their loans.

With all of this chaos in the air, big brother stepped in. "Hey little brother -- I see you're having tough times. Go ahead and loan to those people with good credit. If you need to borrow some money, I'll lend it to you for next to nothing." By lowering the Federal Funds Rate again and again -- eventually to 1% -- the Fed is attempting to give banks the wiggle room they need to be able to start lending again.

Should YOU be concerned?
With the Fed lowering rates, it will effectively drive up inflation, which has both upsides and downsides. Lower rates cause inflation because banks can more easily get money. And when money becomes easier to get, that means that it's worth less. As money becomes worth less, more and more money is required to buy the same things.

At first, this sounds bad. But in reality it can help some people. Those with long-term fixed-rate loans, like student loans or a mortgages benefit greatly from inflation. Essentially, they're repaying a loan over a long time with money that's becoming worth less and less. On the flip side, inflation is the key driver for increasing home values. So those that own homes are seeing inflation drive up the value of their property. Because of the fixed-rate nature of mortgages (though some are variable) and the general increase in property values over time, owning property is, for the most part, a good investment. Without inflation, this theory might be different.

Additionally, most working professionals get a raise every year that resembles the rate of inflation. This raise is often referred to as a cost of living increase. It is meant to offset the burden of inflation so that it has less of an effect on our wallet. So if the cost of goods goes up 3% each year, you're going to be just fine if you get a parallel raise of 3%.

So why should you care about the 1% Fed Funds Rate? If you're a working professional that has a fixed-rate mortgage, owns a home in a stabalizing market, and get a cost of living increase each year, you're going to benefit from slightly higher inflation. Your mortgage will become easier to pay, your home will increase in value, and your annual raises will cover most if not all of your increased cost for everyday goods.

Who should really be concerned?
The elderly that are living on fixed incomes for the rest of their lives should be the ones to worry. They're the ones that aren't borrowing money and the ones that won't get a cost of living increase every year. If they're living in the last home that they'll ever own, it will become increasingly difficult for them to keep the home in their family; unless they sell it or get a reverse mortgage, they won't benefit from inflation driving up its value.

Also negatively affected by lower rates and increased inflation are companies and individuals working on a long-term fixed price contract. As money becomes less and less valuable, the benefit that they'll receive as time goes on will decrease until their contracts are renegotiated.

Keep in mind that banks are included in the list of companies that work on long-term contracts (in the form of fixed-rate mortgages). With the Fed lowering rates, though their immediate costs of getting money may go down, they know that inflation will make the money that they'll receive in future payments worth less. Anticipating the decreasing value of the dollar, they'll need to increase the rates at which people borrow from them. Last week 30-year fixed mortgages were at 5.92%. Today, they've shot up to 6.35%. On a $200,000 mortgage, that rate increase would increase your monthly payment by $55.64.

Because of this significant mortgage rate increase, you should be concerned if you have yet to buy a house. A decrease in the Fed Funds Rate will increase mortgage rates and may therefore decrease homeownership. In 1980, inflation was at an astounding 13.58%. Interest rates for mortgages often exceeded 11%. Therefore, in the early 80s, my parents lived in a trailer.

Summary:
- The rate at which the Fed lends to commercial banks was reduced to 1%
- This gives banks wiggle room and makes it easier for them to make new loans to businesses and individuals
- Those that will benefit from the rate cut are homeowners with fixed-rate mortgages and those with jobs that offer annual cost of living pay increases
- Those that will be hurt are those living on fixed incomes and those committed to long-term fixed-rate contracts
- Increased inflation caused by the decreased cost of money will increase mortgage rates and therefore make it more difficult for first-time homebuyers to afford a home.

In case you were wondering: Yes, I was conceived in a trailer.

What To Do About Student Loan Interest Capitalization

If you're currently in college and have student loans, you may have recently received one or more quarterly interest statements from Direct Loans. Current students are given the option to delay their monthly payments until they're finished with school, though interest may have already began to accrue. This accrued and unpaid interest is what this form details.

Statements will show a current balance along with a figure for Total Unpaid Interest. Though this is not an actual bill, it looks a lot like one because of the clear bold figure indicating how much you might want to pay and the inclusion of a pre-addressed envelope and remittance form. So should you pay it?

The short answer: Yes, you should probably pay it.

Unless you absolutely cannot afford it or if you have debt with a considerably higher interest rate than the student loan, I'd like to see you pay all of the Unpaid Interest. Basically, unless you're dead broke, have high-interest credit card balances, or if you've got a loan shark chasing after you, grab your purse and start writing a check to the U.S. Department of Education.

Here's why: If you make a payment toward this loan -- especially if it's only for the listed amount on the form -- you're going to decrease your tax liability for the current year. If you're in the 25% tax bracket and you have $100 in unpaid interest, a payment of $100 will increase the size of your refund by $25 even if you're using the standard deduction. This $25 far outweighs how much you would save in interest by sending that same $100 to a loan with a slightly higher interest rate that is not tax deductible.

My wife just received a quarterly interest statement for her student loans. Because she's enrolled in grad school, no payment is due at this time. Currently, the interest rate on her student loans is about 1% less than the rate on our auto loan. So I considered letting it ride on the student loan interest and making a larger payment this month on our auto loan. But because the interest on an auto loan is not tax deductible, even with its higher rate it makes sense to pay the Total Unpaid Interest on the tax-deductible student loan.

But keep this in mind: If you have debt with a higher interest rate than your student loans -- like an auto loan -- only pay the Total Unpaid Interest on your student loan, and never more. Payments toward principal-only should always be made to loans with the highest interest rate.

If you don't have an auto loan or credit card balances, consider paying the Unpaid Interest plus whatever extra principal you can afford on your student loan. But if you have more than one federal student loan and receive multiple corresponding quarterly interest statements, don't pay extra principal on a loan until you have paid the unpaid interest on all of your student loans, regardless of their interest rates. Any payment amounts that exceed the Total Unpaid Interest will go toward the principal balance, which is not considered tax deductible. If you can afford to pay more than the Total Unpaid Interest on all of your loans, first, write a separate check for each account's Total Unpaid Interest, and then write an additional check for the account with the highest interest rate (probably a PLUS loan) in the amount of your extra principal payment.

If you're a student and you don't have any credit card debt or a high-interest auto loan, pat yourself on the back!

Paying for college as an adult

I'm getting married in a few weeks to my college sweetheart, Michelle. Currently, she's working for NPR, teaching a film class, and going to grad school. I work for a government contractor doing various types of IT consulting, project management, and technical writing. We're trying to make decisions about how to pay for her grad school that won't put us in the poor house, which is easier said than done, considering the interest on student loans for our generation is sometimes more than double the rate that my GenX friends are paying.

Michelle took out loans to pay for her first year of grad school because that was her only option at the time. But now, a year later, we're both a bit more settled and have stable careers and a little extra income each month. She's in a three-year program, so we've got a bit more financing to do, giving us a few options to churn about. Should we:

1. Take all of our extra income and pay it toward her current loans?
2. Put it into a savings account and pay cash in August when her next tuition bill comes due?
3. Save our money, continue to take out loans, and hope we have enough cash when she graduates to pay off a substantial portion?
4. Utilize a more creative strategy?

We chose number four. After doing some research online, we decided to do two things with the disposable income we're able to dedicate to her education expenses:

1. Save enough in a high-yield savings account (E*Trade is what we use) to pay the accrued interest on her current student loans
2. Put the rest of our dedicated $$$ into North Carolina's 529 plan

Here's our logic:
Since interest rates on graduate loans are in the 8% range, we certainly don't want to increase the principal on which we pay interest if at all possible. I mean, the interest alone on a year's worth of student loan debt comes to over $100 per month. While she's in school, payments are deferred, but interest still accrues. We get our quarterly interest statements and are damn sure to pay every penny of it. Albert Einstein once said, "The most powerful force in the universe is compound interest." You certainly want the most powerful force working for you, not against you! By letting that interest build up over the years she stays in school, the total cost of her college would increase significantly.

After paying her student loan interest each quarter (which is usually a few hundred bucks, never more than $500 I don't think), we figured out how much more we could contribute toward her college expenses (around $250 per month). All of that money has been placed into a 529 plan. Here's why:

The account's funds, which may only be used to to pay only for the named beneficiary's college tuition and related expenses, has tax benefits which are two-fold (depending on which state you're in). In the state of North Carolina, contributors may write off up to $2,500 in contributions from their state taxes. Additionally, the investments in the plan grow tax free, as long as the money in the plan pays for qualified college expenses (sorry, beer and pizza aren't qualified).

529 plans are to college as Roth IRA plans are to retirement. Only after-tax money is contributed, but as long as it's used for its intended purpose, that money is never taxed again. The risk that you run with 529s is that the beneficiary never goes to college. With Roth IRAs, you run less risk because you're only betting that you're part of the human circle of life and will reach the qualified retirement age before you die (and if you die young, who cares about the money?). The nice thing about putting money into a 529 plan for someone that is about to start college or has already begun is that the risk of them not attending is significantly mitigated.

To recap the benefits of our college financing strategy, consider this:

1. All of the money we have saved for Michelle's college is growing tax free
2. Up to $2,500 of her out-of-pocket college expenses are tax-deductible (again, this depends on your state)

To read more about 529 plans, click here