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How Federal Interest Rates Affect Personal Loans

Joseph Schwartz

Joseph Schwartz

Head of Content at Funding Hero |

When the Fed raises or lowers the interest rate, it's usually big news, especially in economic circles. But the federal rate isn't the rate you're charged on a loan — otherwise everyone approved for a loan during the same time period would pay the same amount in interest. If you've ever examined rates on credit cards, mortgages, or other loans, you know this isn't the case.

But federal interest rates do inform personal loan rates. Find out what you need to know about the relationship between federal rates and personal loans below.


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What Is the Federal Interest Rate?

It's easy to get confused about what different interest rates actually are. For example, in September 2019, the Fed lowered its policy interest rates by a quarter percent. That brought interest rates to between 1.75% and 2% at that time. And yet, you'd be hard pressed to find anyone with a personal loan or credit card that has an interest rate that low (unless someone had a temporary 0% APR introductory offer on their card).

That's because the Fed doesn't mean to mandate an interest rate across all types of borrowing throughout the nation. Instead, the Fed sets a guide that's called a target rate.

The target rate acts as a signal for economic factors, but it's also used by many lenders to set a prime rate. The prime rate is typically 3% above the target rate. So, when the short-term lending target rate is 1.75%, the prime rate is 4.75%.

The prime rate is what lenders charge their most credit-worthy borrowers. Typically, those are corporate borrowers or other banks, not individuals seeking personal loans.



Why Are Mortgage Loans Often Under the Prime Rate?

The prime rate tends to have less of an impact on certain secured loans or long-term loans than it does on short-term loans, lines of credit, and credit cards. In part, that's because banks can take certain risks with secured loans that they can't with unsecured lending. If someone doesn't pay their mortgage or vehicle payments, the bank can take back the security (the house or car) and sell it to recoup some losses. That's not true with unsecured loans.

Another reason that some loans seem to fly in the face of the prime rate is that in modern economics, the prime rate is simply an index. It's a signal to financial institutes about the general state of certain economic factors and a number that can be used to calculate unique interest rates.


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How Do Federal Rates Impact Personal Loans?

Short-term loans, however, tend to rely more heavily on the prime rate. Many lenders use the prime rate as a base for determining how much interest to charge someone. The basic concept of the formula is:

Your APR = Prime Rate + a Unique Premium

The unique premium is determined by the lender's own policies and typically incorporates factors such as creditworthiness, whether or not collateral is being used, income, and debt-to-income ratio.

In short, the lender uses a variety of factors to determine how big of a risk you are. If the lender sees you as someone who is highly likely to pay back the funds as agreed, the premium is typically lower. That results in a lower interest rate on your loan.



What's the Real Impact of Interest Rates on Your Personal Loan?

Interest rates are one of the main factors in the total cost of your loan. If all other things are equal (such as how much you borrow and the time you pay it back within), a higher interest rate means a more expensive loan.

How much more expensive? Check out the personal loan example below to find out how interest rates can impact how much you pay for your loan.

Someone borrows $5,000 for three years. Discover how much they'll pay monthly and in total at various interest rates:

Interest RateMonthly PaymentTotal Interest Paid Over Life of LoanTotal Paid Over Life of Loan

You can see that just a half a percentage point brings the monthly payment up $1 and increases the total cost of this loan by more than $40. But the higher the rate goes, the more expensive the loan gets. The additional expense from a higher interest rate is felt even more if you take out a loan for a longer term, such as five years.


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Other Ways the Fed Rates Impact Personal Loans

If the Fed raises interest rates, that means the prime lending rate has increased. That makes it more expensive for banks themselves to borrow money, which might mean those banks have less cash reserves. Banks with smaller reserves can't lend as much money, making loans a more competitive space. When interest rates are high, it might be a bit more difficult (but certainly not impossible for everyone) to qualify for personal loans.



Why Doesn't the Rate Stay the Same All the Time?

You can see that the federal interest rates are only a small part of the overall formula that leads to your interest rate on a personal loan. But this base guideline does impact your rates, so you might wonder why the Fed doesn't just keep this rate low. Why complicate matters by making changes to the target rate?

The Fed uses the target rate to help control the economy. Raising the rate can bring inflation down and lowering the rate can lead to economic growth. The Fed tries to strike a balance that helps ensure a stable economy, but that means making tweaks to the target rate periodically.



What If the Rate Goes Down Later?

If the prime rate impacts your personal loan interest, what if it goes down after you take out a loan? In many cases, the prime rates don't go up or down enough to make that big of a difference over the life of a personal loan. Personal loans tend to have terms no more than five years.

It takes up to a year and a half for a Fed interest rate change to trickle down and impact the entire economy. Chances are, you may be well on your way to paying off a personal loan — or have already paid it off — before you'd see any significant benefit from lower rates.

However, you do have the option of trying to consolidate or refinance loans. This involves taking out another loan and using those funds to pay off existing debt. If the target and prime rates have gone down enough, you may be able to get a loan for a slightly lower interest rate. Although if the change is a fraction of a point, you won't save that much in the long run (as you might with a larger, longer loan such as a mortgage).

Most people would consider refinancing at this point a waste of time. And since you might have to pay fees to do so, you might not save anything at all. There is, however, a time when you might want to refinance personal loans. That's if you've brought your personal credit score up significantly. You may be able to get a much better interest rate — and more significant savings — because of your increased creditworthiness.




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