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 if You're Upside Down on Your Mortgage and Need to Move?

In my previous post about being upside down on a mortgage, I said that you're probably not going to be able to move anytime soon. Well, what happens if you're upside down and need to move? You have options, but none of them are magical or ideal. This post will describe a few of them: borrowing money to make up the difference, negotiating a short sale, and foreclosing.

Two big variables that will greatly affect your situation are 1) the amount you are upside-down and 2) the degree to which you can afford to keep paying your mortgage. If you are upside down $50,000 versus $5,000, you're in a much more difficult situation. Likewise, if you're able to keep making your mortgage payments until you figure out a long-term solution, you're in a much better position than someone who is unable to make his or her payments. If you can't make your payments now, consider renting out the home after you move or drastically changing your current budget to make ends meet. When you move, rent a small inexpensive place. If your kids are in college, consider asking them to take time off or to absorb some of the costs themselves. Major lifestyle changes are difficult, but the effects of a foreclosure or a short sale can be detrimental; all efforts should be exhausted to ensure that neither of those two occur.

If you are upside down on your mortgage and are put in a position where you need to move -- whether it's because of a job transfer or an unexpected layoff -- the most ideal option is to keep your home until you are no longer upside down. This can be achieved by saving money to match your negative equity or waiting for the market to pick up. Three alternatives are described below in order from best to worst as they relate to your overall financial (and emotional) wellbeing.

Option 1: Borrowing the money
This is an option as long as you're slightly upside down and not really upside down. If your negative equity is no more than $10,000, you're not in such a tough place. By borrowing money to get out of the pinch, you're protecting your credit score from getting hit by a train and ensuring that you'll be able to get another loan sometime in your lifetime.

The best place to get a loan for $10,000 or less would be from a friend or family member. But if you borrow money from someone, they'll need to charge you interest (at least 4.52%) in order for the IRS not to consider it a gift. A person is allowed give gifts to another up to $12,000 per year.

If you're fresh out of rich relatives, there are other places to look. If you, your child, or your spouse is enrolled in college, you may be eligible to take out an additional student loan. The federal government will allow students and parents to borrow money in excess of actual tuition and fees to cover living expenses. It would not be uncommon for students and parents to be able to borrow an extra $7,000 or $8,000 per semester which is available in cash. These loans have a relatively low interest rate (between 6% and 8%), are repayable over a long period of time, and their interest is generally tax deductible.

I hate to say it, but if you're unable to get a favorable loan from a family member or the government, you may have to resort to using a credit card convenience check or obtaining a high-interest personal loan. I'm not usually a proponent of putting things on your credit card that you can't pay off immediately. But in this case, when a foreclosure or a short sale are your only other options, the convenience check is the lesser of two evils. I'd rather see you incur five or ten thousand dollars of credit card debt if it means you'll avoid a foreclosure or a short sale.

Option 2: Negotiating a short sale
Short selling is when you negotiate with the mortgage lender to accept a fair market price for the home instead of the amount that you actually owe. This is more likely to be accepted when home values in a certain area have dropped significantly. Though mortgage lenders are not required to modify your agreement and accept less than you owe, they may be willing to because it may prevent a foreclosure, which is very expensive for a bank. Basically, they would rather forgive $10,000 on your loan than incur $70,000 in costs associated with a foreclosure.

Short selling is similar to foreclosing, but it will ultimately cost the bank less money and permit you to buy another home a bit sooner. It is preferable to a foreclosure, but is only offered by some lenders to some borrowers, depending on the circumstances. I had to do a bit of research to confirm this, but short-selling on your home will cause as much immediate detriment to your credit score as a foreclosure.

Expect your FICO score to drop 200 or 300 points. Your new score will most likely preclude you from qualifying for a rental lease without a cosigner. However, with two years of good credit history following a short sale, you will probably be able to obtain a mortgage through special government-sponsored programs. If you had foreclosed, you most likely would be unable to qualify for another mortgage for at least four years.

If you want to short sell your home, two things need to happen. 1) The mortgage lender has to be willing (it helps to have a lawyer assist with the negotiations) and 2) you need to prove your insolvency. Basically, you need to show that you have no money that can be freed up to pay for the difference between what you owe and what the house is worth. If you have equity in another property, a car that is paid off, or a student enrolled in college, the bank will see these things and ask why you're not dipping into your other equity, selling the car, or taking your kid out of college to pay what you has originally agreed. Essentially, before the bank concedes a short sale, they will need to be assured that foreclosure is the only other option because you have no other means to repay the loan.

Option 3: Foreclosure
This is clearly the worst thing for everyone. Your credit score will be destroyed and its affects will be long lasting. You will be unlikely to receive any other type of loan for a few years. The only good news is that no negative item - including a foreclosure - can stay on your credit report for more than seven years.

Being upside down on a house is a tricky situation -- especially for those that need to move. If you're upside on the mortgage for your current residence, save as much as you can so you can eventually bring get rid of the negative equity. If you need to move, do whatever you can to keep the home until house values go back up. If you cannot keep the home, try to borrow money from a friend or from the Department of Education. Remember that it's better to put an extra five or ten thousand dollars on a credit card than go through a short sale or foreclosure. If you're unable to obtain the cash to get out of the red, try to negotiate a short sale. It's effects on your credit are detrimental, but not as long-lasting as a foreclosure. If your lender is unwilling to engage in a short sale, then foreclosure may be your only option.

Guidelines for accelerated loan payoffs

If you've been frustrated with the faltering markets lately, as have most Americans, you've probably been discouraged from investing your disposable income into the stock market. That could very well be the correct choice for you and your family, depending on your financial plans and tolerance for risk. But if you're not investing in the stock market, what are you doing with all that money? Are you putting it in a savings account? Or a CD? Or are you paying down debt?

My personal financial plan calls on paying down my debt during the economic downturn. The markets have been unpredictable (and by unpredictable, I mean they're going straight down) and the amount of debt that my wife and I have will take a relatively short amount of time to pay off. We're hoping that when we're out of debt in a couple of years (excepting our mortgage), the market will be trending upward and we'll have a larger portion of our income to regularly invest, given the fact that we'll have no regular payments for our auto or student loans.

If you're going to start paying down debt in lieu of investing, consider the following three guidelines to help you prioritize where your money is being sent:

1. Pay off the loans with the highest interest rate first (as long as they're not tax advantaged)
Dave Ramsey will tell you to pay off your loan with the smallest amount first instead of the one with the highest interest rate. This adds a layer of subjectivity to your personal finance that, while making you "feel good" about paying down your debt, will cost you money. In a recent post, I discuss the financial disadvantages his plan.

Non-tax-advantaged loans that fall into this category include credit card debt, personal loans, and auto loans. Look for your highest interest rate, and start sending whatever extra money that you can to pay it off.

2. Pay off loans incrementally -- don't save your money and pay it off in one fell swoop
I'll give a personal example here. Though I still have a couple of years' worth of payments remaining on my auto loan, I'm hoping to have it paid off by January. While maintaining my "emergency fund" in my checking account, and have been placing my monthly disposable income into an "auto loan payoff fund" that lives in a savings account. Last I checked, I had a few thousand dollars in there.

I had originally planned to keep making my regular monthly payments and continue saving money in the payoff account until I had enough money to pay off the car. But then I crunched a few numbers and found the flaw in my plan. Here's how it goes:

Whenever you make a regular monthly payment on a loan, a portion of that payment goes toward the principal balance and another portion goes toward interest. Those percentages are determined by a couple of different factors:
1) the time left on the loan (the less time left, the higher the percent that goes toward principal) and
2) the amount of remaining principal balance (the lower the balance, the higher the percent that goes toward principal).

So if my monthly payment is $500, maybe $400 of that goes toward principal and the other $100 goes toward interest. Next month, after the principal balance has been slightly reduced, the payment distribution may be $405/95, and so on. But if I have a few thousand dollars in a savings account that's just waiting to be used to pay off the loan, I am better off sending that money as a principal-only payment immediately. If I reduce my principal by, let's say, $5,000, a much higher percentage of my regular monthly payment will go toward principal. If you're paying off a loan on an accelerated schedule, sending the extra money as soon as you have it instead of saving it and sending one big fat check at the end may save you several hundred dollars over the life of the loan.

3) After non-tax-advantaged loans are repaid, evaluate the tax benefits of other loans before repaying them.
Once your credit cards, personal loans, and auto loans are paid off, hopefully all you'll have left is a mortgage and maybe a student loan. At this time, before deciding to accelerate the payoff on these loans, you should reevaluate the stock market. Has it picked up yet? If you're still not feeling warm and fuzzy, do some math and figure out how much your tax-advantaged debt is really costing you.

If your mortgage has a 5% interest rate, remember that depending on your tax bracket, you'll get maybe 25 or 28 percent of that interest back in your tax refund. So think of the effective cost of the debt to be 3.75% (5%, minus 25% of the 5). Your mortgage is a very long-term loan, and you won't see the benefits of paying it down early for a very long time. Paying it off early won't reduce your monthly payments. Sure, it will be paid off sooner, but even if you double your monthly mortgage payment every month until it is paid off, it will take almost 10 years to pay off a 30-year mortgage. If the effective interest rate on your mortgage (the interest rate less the tax benefit) is only slightly higher than the amount you could earn in a CD or a savings account, I would rather see you hold onto that money just in case you need it.

With all loans, especially those that are tax-advantaged, the lower the interest rate, the less sense it makes to accelerate your payoff. My friend Quang's student loan has a 3% interest rate. I wouldn't pay that off early for the world. But the rate on one of my wife's student loans is 7.9%. I can promise you that as soon as my car is paid off, the next thing to go will be that sucker.

Non-tax advantaged debt is nobody's friend. If you're not satisfied with the performance of your investment portfolio, it could be a wise decision to pay it off early in lieu of investing. But if your only debts are mortgages or student loans, think twice before you start sending extra cash toward the principal. True, you're saving yourself money in the long run, but remember that you're also reducing your tax writeoff and parting with that money for a long, long time. And keep in mind: even if you're using the standard deduction (not itemizing), your student loan interest is still tax deductible!

What to do if you're upside down on your mortgage

Also see my related post: What if You're Upside Down on Your Mortgage and Need to Move?

A lot of blame for the housing crisis is placed on "sub-prime" borrowers and the banks that loaned to them. It is true that at one point earlier in the decade it was probably too easy for someone with bad credit to obtain a loan. But declining house values and the subsequent emergence of negative equity also affected many intelligent, well-educated homeowners with decent credit. Many of them Gen Xers and Gen Yers that were buying their home because they were entering the home-owning phases of their lives -- not because low-payment mortgages were falling from the sky like raindrops.
Many of these homeowners that are in trouble had simply overestimated their luck in hopes of making a good investment. I'm sure that many of them, before buying a home, analyzed the cost of renting vs the cost and appreciation associated with owning. Given the numbers at the time, buying made sense. Additionally, many of the homeowners in trouble believed their lenders were looking out for their best interests; a belief that was unfortunately discredited for thousands. And TV shows like HGTV's "My House is Worth WHAT?" gave intelligent homeowners false hope about the financial returns they could receive by spending thousands on home upgrades (and financing them with home equity lines of credit).
So if you find yourself in an upside-down situation, what do you do? Should you pay down your balance until your equity is positive? Not necesarily. You should treat your loan -- upside-down or right-side-up -- just like any other loan that you're considering to pay off early. The higher the interest rate on your loan and the lower the interest rate at which you can save, the more sense it makes to pay extra. But if you have a reasonable rate, let's say below 6.5%, I'd rather see you hold on to your money. Throwing more money at your morgage isn't going to increase the value of your home. Only time and inflation will.

If you're upside down on your mortgage, don't expect to be able to move anytime soon. Save as much money as you can in an interest-bearing savings account that is easy to access until the time comes to sell your house. If you're able to wait long enough, your upside-down issue will eventually correct itself. If you need to sell before then, your savings will enable you to send a heap of cash to your lender a week before the sale, bringing your equity back into the green in one fell swoop.
In the future, never forget the old addage "if it seems too good to be true, it probably is." I'm not saying that good investment opportunities don't exist. They certainly do. But truly exceptional opportunities rarely exist in the stubborn, slow, and steady real estate market. If you ever see your equity in your home growing faster and faster faster to a level that you can't believe, be cautious. It's like watching a racecar driving 300 miles per hour (they usually don't go much faster than 200). Sooner or later, it's going to crash.