The Impact of the Federal Funds Rate on Your Credit Card Interest Rates

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There is no way to know for sure, but the Federal Reserve appears poised to raise interest rates once again this summer. And if that should occur, American credit card users will be paying more in interest charges.

How Credit Card Interest Rates Are Determined

In the past, credit card issuers would advertise so-called "fixed" rates, yet they were always free to raise customer's rates at any time for a variety of reasons. Many cardholders found this practice to be unfair and deceptive. As part of the CARD Act of 2009, credit card issuers became restricted from advertising "fixed" rates unless they were truly fixed. Instead, nearly all credit card issuers began offering "variable" rates that were pegged to the Prime Rate, which itself is based on the Federal Funds rate. Now, credit card interest rates are commonly cited as "Prime plus," a particular rate that varies by the credit card and the creditworthiness of the cardholder at the time of application.

However, this change in the law happened to coincide with the Prime Rate being unchanged for the longest period in history. From December 16, 2008 to December 17, 2015, the Prime Rate was at 3.25%, and subsequently, the rate was raised to 3.5%. The Prime Rate rose because the Federal Reserve, often simply referred to as the Fed, decided to raise the federal funds rate, which is the rate banks charge each other for overnight loans in order to meet reserve lending requirements.

How the Federal Funds Rate Is Set

The Federal Reserve Bank's Open Market Committee meets in secret eight times a year to discuss the current state of the economy and consider whether to raise or lower rates. In general, it tends to raise rates when the economy is strong and they are worried about inflation, and lower rates when the economy is weakening and they want to spur growth. Recent positive economic indicators have lead Fed watchers to speculate that it will raise rates again this year, which will result in a commensurate increase in the Prime Rate, as well as standard interest rates for nearly every credit card issued in the United States.

What This Means for Credit Card Users and the Economy

According to the most recent Gallup survey, about half of American credit card users regularly carry a balance on one or more of their credit cards. When the Fed raises rates, and the Prime Rate rises, nearly all of these cardholders will immediately begin incurring interest charges at a higher rate. This means that a larger percentage of their payments will go towards interest costs, rather than paying off their principal. And while the impact of a 0.25% increase will have small, but significant impact on individual cardholders, the collective impact on the consumer spending and the economy as a whole will be larger as consumers will have less disposable income.

What You Can Do to Minimize Interest Charges

First, it's always better to avoid costly credit card interest charges by paying off your balance in full each month. But if you are unable to do so, there are still other steps that you can take to minimize your interest charges. First, you can contact your bank and ask for a lower rate, especially if your credit card account has been open for at least a year and you have a strong record of on-time payments. In addition, you can consider applying for a card with a 0% intro APR promotional financing offer for balance transfers. Finally, it's always worth shopping for a new credit card with the lowest possible standard interest rates, keeping in mind that cards that offer rewards will invariably have a higher standard interest rate than a similar card that does not.

By understanding how credit card interest rates are set, and why they are likely to rise, you can take steps to minimize the amount of credit card interest that you pay.

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