The Fed did what everyone expected this past week, cutting the federal funds rate by 75 basis points to 2.25%, a little less than what the market wanted (they wanted a full 100 basis point cut down to 2%). The federal funds rate has gotten a lot of press lately and many people have started to understand how the Fed Rate personally affects them. Some have been confused between the federal funds rate and the federal discount rate, which I tried to explain in the past, and wanted to learn why the fed rate affected the stock market, but overall I think it’s relatively well understood. The other popular rates that aren’t as well understood are the Prime Rate, the London Interbank Offered Rate (LIBOR), and the 11th District Cost of Funds Index (COFI).
What is it? The prime rate is a generic term but in the US it primarily refers to the the Wall Street Journal Prime Rate. It is “the base rate on corporate loans posted by at least 75% of the nation’s 30 largest banks.” [Source: Wikipedia] Usually you can expect the rate to be about 3% higher than the Federal Funds rate so when the Fed drops its rates, you can expect the Prime Rate to fall as well (but not always). WSJ prints this rate about once a month.
Why does it matter? The Prime Rate is often the rate you see associated with credit cards, car notes, and all other types of consumer debt. For example, a card may have their variable purchase and balance transfer APR pegged to the Prime Rate plus 4.99%, so that rate will be the Federal Funds rate plus around 8.99%. Since the Fed cut the rate by 75 basis points, you should expect a similar fall in your interest rates. The Prime Rate is published by WSJ so it will lag the Fed by a little bit, so you might not see the lower rate for a little while.
London Interbank Offered Rate (LIBOR)
What is it? The LIBOR is “a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market).” [Source: Wikipedia] In other words, it’s the Fed funds rate in London. Some other notable differences are that it’s a daily rate, announced after 11 AM by the British Bankers Association, and is an average of rates on inter-bank loans of up to 1 year with contributor banks. It’s a lot like taking a snapshot of the crowd at a sporting event, you get close but it’s obviously a continually moving target. Another difference between the two rates is that with the Fed funds rate you’re talking about the target that the Fed is trying to hit by adding liquidity. With the LIBOR, it’s the actual rate being charged and not a target. While it is an academic difference, it’s a difference nonetheless.
Why does it matter? Some adjustable rate mortgages are actually linked to the LIBOR, such as LIBOR + 2.75% or LIBOR + 2.0%; so when the LIBOR moves around, it can affect what your ARM is adjusted to.
11th District Cost of Funds Index (COFI)
What is it? Last but not least, we have the 11th District Cost of Funds Index (COFI), an index I never heard of before researching this article. The COFI is a little more complicated and is “computed from the actual interest expenses reported for a given month by the Arizona, California, and Nevada savings institution members of the Federal Home Loan Bank of San Francisco (Bank) that satisfy the Bank’s criteria for inclusion in the COFI (COFI Reporting Members).” [Source: FHLBank San Francisco] Like the Prime Rate, this rate is reported on a monthly basis but two months behind (so the January value is reported in March).
Why does it matter? Again, it’s an index used to adjust mortgages and other loans and it’s popular because it lags the market and is a stable measure. This means that it’s good when the rates are increasing, since it lags, but not as good when the rates are falling, since it lags. The reason why its stable is because it includes more factors such as loans from savings and checking accounts, CDs, etc.
Hope that clarifies things just a little bit more…