By Frances Coppola | American Express Credit Intel Freelance Contributor
4 Min Read | July 17, 2020 in Cards
There tends to be a close relationship between Federal Reserve interest rates and credit card interest rates.
Usually, when the Fed cuts interest rates, credit card interest rates fall too.
But even when the Fed cuts rates to 0%, credit card interest rates don’t fall to zero since they’re also influenced by other factors.
When the U.S. Federal Reserve cuts interest rates, credit card interest rates often fall too. But how is it that Fed interest rate cuts influence credit cards? And why are credit card interest rates often higher than the interest rates we see being discussed in the press?
To help clarify the relationship between Fed rate cuts and credit card interest rates, here’s an overview of how credit card rates generally work, and how Fed rate cuts flow through the financial system to influence credit cards.
Credit card interest rates are typically based on the “prime rate,” which is the interest rate that banks charge their best, or “prime,” customers – those they think are least likely to default on their loans. For other customers, banks and credit card issuers add a “default margin” to the prime rate. The lower a borrower’s credit score, the higher the margin. So, someone with an average score typically has a higher interest rate on their credit card than someone with a top credit score.
The prime rate is published every day.1 But in reality, there isn’t a single prime rate. Each bank sets its own prime rate: the published rate is actually an average of the prime rates from major banks. To understand how credit card companies use these rates to calculate interest charges, read “How to Calculate Interest Rates.”
Whatever the interest rate on your card, it will probably fall when the Fed cuts interest rates, unless it is a 0% intro APR credit card or you are still in another type of introductory low rate period. Similarly, the APR on your credit card will likely rise when the Fed raises rates. Here’s how this works.
The Fed’s main job is to adjust interest rates to meet its stated inflation target, currently set at 2% per year. If inflation looks as if it’s rising above target, the Fed may raise rates; if inflation is set to sink below the target, the Fed may cut them. For more on how interest rates influence inflation, read “Inflation 101: Meaning and Causes.”
But the Fed doesn’t directly control interest rates, including the prime rate. Instead, it sets a “target range” for the Federal Funds Rate, which is the rate at which banks lend to each other for short-term loans they may need. It’s typically about three percentage points lower than the prime rate, and the lowest cost of funding for banks.
So, when the Fed cuts interest rates, what it actually does is lower the target range for the Federal Funds Rate. For example, if the target range is 1.00%–1.25%, and the Fed cuts rates by 0.25%, the target range falls to 0.75%–1.00%. The Fed uses the theory of supply and demand to get interest rates to fall into its desired target range: it buys and sells securities, which increases or decreases the total supply of money available in the economy. But it doesn’t aim to hit the bottom of its desired range. Instead, when headlines say “Fed cuts interest rates to 0.75%,” the Federal Funds Rate is actually somewhere between 0.75% and 1.00%.
Banks and credit card companies earn their keep by charging higher interest rates on credit cards and other lending than they pay on deposits and other forms of funding. When the Fed reduces its target range, banks’ cost of funding falls. Usually, they pass this on to customers by cutting the prime rate, which reduces interest rates on loans and credit cards. Because credit cards typically have variable interest rates, when the Fed cuts interest rates, chances are that lower interest on credit cards will be one result.
The Fed started reducing rates in 2019 after raising them to over 2% between 2015 and 2018, but in 2020 it has cut the target range to 0%–0.25%.2 If your credit card interest rates are moving in alignment with those changes, they can vary considerably.
In February 2020, the average APR for all U.S. credit card accounts was 15.09%.3 That’s the lowest it has been in about three years, but it’s a long way above the U.S. prime rate of 3.25%. For average credit card interest rates to fall to zero, both the Federal Funds Rate and the prime rate would have to be well below zero – or what’s commonly referred to as “negative rates.” But many cards have introductory offers of 0% APR on balance transfers and/or purchases, and introductory periods can last as long as 18 months. So whether the Fed is cutting rates or not, it’s worth shopping around for credit card offers.
Credit card interest rates typically fall when the Fed cuts interest rates. But it’s unlikely that credit card interest rates would fall to zero, even if the Fed announces interest rates of zero. There are two main reasons. First, credit card interest rates are based on the prime rate, which is typically higher than the Federal Funds Rate. Second, credit card issuers usually add a “default margin” to credit card interest rates, which reflects the holder’s credit score.