The Federal Reserve doesn’t directly set personal loan rates. But its monetary policies are designed to have a widespread effect on the U.S. economy. When the central bank makes a policy move — such as December’s 0.25-percentage-point rate cut — it creates a chain reaction that trickles down to personal loan interest rates.
Borrowers with an existing fixed-rate personal loan won’t need to worry about their interest rate changing in reaction to these Fed moves. But if you’re shopping around for a new personal loan or you have one with a variable interest rate, the Federal Reserve can impact the rate you pay throughout the loan term. Read on to learn how.
[Read: Best Personal Loans.]
How Does the Fed Impact Personal Loan Interest Rates?
The Federal Reserve’s monetary policies influence interest rates on many financial products, from credit cards to mortgages and personal loans.
Federal Funds Rate
One way the Fed guides the direction of the economy is by controlling the federal funds rate, which is the benchmark rate banks use for overnight lending.
Raising or lowering the federal funds rate can have a ripple effect on other rates that are tied to it. For instance, the prime rate moves with the Fed rate and acts as the underlying index for many loan products. Lenders use the prime rate to determine what to charge borrowers, including people who apply for personal loans.
A higher Fed rate increases borrowing costs for banks, so they’ll transfer those higher costs onto consumers by increasing the prime rate. Banks usually calculate the prime rate by adding 3 percentage points to the federal funds rate. With December’s cut, the Fed target rate is 4.25% to 4.5%, meaning the prime rate should drop to 7.5%.
A series of Fed rate hikes caused personal loan rates to increase in the last couple of years. Between March 2022 and July 2023, the Federal Reserve increased the federal funds rate 11 times in an effort to cool down inflation. The prime rate increased from 3.5% to 8.5% during the same time frame. Average personal loan rates followed suit, rising from 9.87% in 2022 to 12.49% in early 2024. The Fed changed course in September when it opted to cut rates by half a percentage point.
Buying and Selling Securities
The Fed can also trade securities to control the money supply and influence interest rates. This is called “open market operations.”
For instance, the Fed often buys long-term U.S. Treasurys to reduce their yields, which often leads to lower market rates (which can include personal loans). The Fed can also sell securities for the opposite effect.
“U.S. Treasurys are considered risk-free and are the basis for all other interest rates in the economy,” says Aleksandar Tomic, associate dean for strategy, innovation and technology and the program director of the master of science in applied economics programs at Boston College.
“When yields on U.S. Treasurys go up, rates on personal loans will go up as well,” Tomic says. Essentially, “the borrower has to convince a lender to lend to them instead of the U.S. government, which has zero risk of default.”
[Read: Best Low-Interest Personal Loans]
Does It Impact Existing Personal Loans?
If you already took out a personal loan with a fixed interest rate, then any future decisions the Fed makes won’t affect your personal loan. “The Fed’s policies will not impact someone with a fixed rate, unless they try to refinance or are looking for a new loan,” Tomic says.
A fixed rate stays the same throughout your loan term, no matter what happens with the prime rate or federal funds rate. However, changes to the Fed rate could impact personal loans with a variable interest rate.
Fixed vs. Variable Rate Loans
When you apply for a personal loan, you may have a choice between a fixed rate or a variable rate. Here’s how the Fed’s decisions may impact both types of loans.
Fixed-Rate Personal Loans
Most personal loans come with a fixed interest rate that never changes throughout the loan term. These loans come with fixed monthly payments that offer predictability. When the Fed changes its benchmark interest rate, lenders often do the same with the rates they charge borrowers.
In a low-rate environment, you could save on interest costs when taking out a personal loan. But the opposite is true, too. When the federal funds rate rises, you’ll typically pay a higher interest rate when you take out a new personal loan.
Variable-Rate Personal Loans
Some personal loans come with variable interest rates that may change anytime during the loan term. Variable rates usually start low, making them attractive to borrowers who want to save on interest. But borrowers take a risk that the rate will increase at some point. Lenders usually adjust the rate based on changes in the loan’s underlying benchmark, which is often the prime rate.
“If the Federal Reserve raises interest rates, the variable rate on an existing personal loan is likely to rise,” says Hugh Johnson, an economic adviser to the chairman of the New York State Assembly Committee on Ways and Means. “It will cost the consumer more each month going forward.”
The specific rate change and how frequently it can change depends on the terms of the loan. “In the early years of the loan, interest is the largest portion of the payment, so changes in the interest rate will have a large effect on the monthly payment,” Tomic says. “In more mature loans, the effect is smaller.”
You may be able to avoid further rate changes by taking out a fixed-rate debt consolidation loan. This move effectively refinances your debt and eliminates rate increases.
[Read: Best Debt Consolidation Loans.]
Are Personal Loan Interest Rates Expected to Increase or Decrease?
Personal loan interest rates will potentially go down because of the Fed rate cut. To get the best personal loan rate, though, work on improving your credit score and pay down your existing debt, if you can. Also, comparing interest rates, fees and other terms from a few different lenders can help you find the best deal.
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How the Federal Reserve Impacts Personal Loans originally appeared on usnews.com
Update 12/18/24: This story was previously published at an earlier date and has been updated with new information.
