What the Latest Federal Reserve Rate Increase Means for Consumers
The Federal Reserve raised its benchmark interest rate, which will increase rates on loans from mortgages and auto to credit cards.
WASHINGTON, D.C. – In its latest meeting, the Federal Reserve Federal Open Market Committee (FOMC) decided to raise the target range for the federal funds rate by 25 basis points. A majority of FOMC members also signaled they anticipate another rate increase later this year. These moves may help stem inflation over the longer term, with an intended goal of greater price stability. But, over a shorter period, they will raise interest rates on multiple consumer credit products, from mortgage rates and auto loans to credit cards. While it may be widely understood how higher rates immediately impact mortgage rates, we examine what this means for credit card rates below.
How the Federal Reserve Rate Decision Will Affect Credit Card APRs
To understand how a change in the Federal Reserve’s benchmark rate affects credit card APRs, it is helpful to start with the concept of the cost of funds. As CBA has discussed previously, the cost of funds represents the cost a lender pays to obtain the money it ultimately lends to consumers. Just as consumers pay interest when they borrow money, banks incur a cost to obtain the funds they use to make loans. That cost is an important input into the price of credit and is influenced by broader interest-rate conditions, including the federal funds rate.
For credit card lending, this is particularly important because credit cards are revolving lines of credit. Banks must continuously fund outstanding balances and maintain the capacity to provide additional credit when consumers need it. The cost of that funding is therefore an important consideration in setting the price of credit.
Underlying the cost of these funds for most variable rate credit cards is the prime rate - which is often used as a reference or “base rate” for many types of loans - including personal loans, small business loans, and credit cards. Importantly, the prime rate provides the most direct connection between Federal Reserve policy and most variable-rate credit card APRs.
When the Federal Reserve changes the federal funds rate, the prime rate generally moves in the same direction, which in turn changes the interest rate charged on credit card balances. In this way, changes in monetary policy are transmitted relatively quickly to the cost of carrying a credit card balance.
Figure 1 illustrates this relationship, showing how changes in the prime rate track changes in the federal funds rate which have flowed through to credit card APRs and, ultimately, the actual total cost of credit for credit cards since 2022.
While the federal funds rate and the prime rate reflect prevailing short-term funding conditions and serve as the benchmark for many variable-rate loans, credit card APRs also have to price in several other factors. In addition to the prime rate and cost of funds, a consumer's APR also accounts for the operating costs of maintaining a credit card program, expected losses from borrowers who do not repay, and the capital that banks must hold against unexpected losses.
In his latest research piece on credit card APR increases, Dr. Paul Calem finds that “[i]ncreases in general market interest rates, which affect banks’ cost of funds, account for about half of the increase in the average credit card interest rate over the past decade. The remaining half appears to have been driven by developing credit risks, as reflected in a long-term upward trend in the card delinquency rate...”
This distinction is important when considering what drives credit card pricing over time. The federal funds rate directly affects the funding component of an APR, which is why changes in the federal funds rate can flow through relatively quickly to variable-rate credit cards.
The Bottom Line
Unlike fixed-rate loans, most credit cards have variable APRs tied to the prime rate, which moves closely with the federal funds rate. The latest decision by the Federal Reserve to increase rates and the projection of an additional rate increase this year will increase APRs and the cost to carry a balance.
With households facing elevated essential expenses and unexpected financial shocks, credit cards remain an important source of liquidity that helps them manage short-term financial needs.
As these measures evolve, it is important to distinguish between the financial pressures and shocks consumers face and the tools they rely on to absorb them.