Oct. 30, 2008 at 8:00 AM ET
Not everyone is happy about the Fed's half-point rate cut on Wednesday. Anyone who relies on interest income from bank certificates of deposits or other savings tools is about to see that income slashed. With each step down the Fed takes in interest rates, savers get pinched.
Bank CDs and money market rates are not formally tied to the targeted federal funds rate, but they generally move in parallel. The last time the Fed rate was at 1 percent -- for a year from mid-2002 to mid-2003 -- CD rates plummeted to a little over 2 percent.
"I remember there was quite a bit of pain," said Liz Weston, personal finance expert and author of "Deal With Your Debt."
The difference can be more than it might seem at first blush. If CD rates drop from 2.5 percent to 2 percent, a saver's income plummets by 20 percent.
"It can be really tough. People have gotten pretty used to supporting an OK lifestyle just on interest," Weston said.
Internet-only savings accounts, like those offered by ING Direct, HSBC, and others – which have higher yields than their brick-and-mortar competitors -- have also taken it on the chin as lending rates have dropped. On Oct. 9, one day after the last Fed rate cut, ING Direct lowered its savings rate from 3 percent to 2.75 percent, for example.
There is hope for those who are counting on the safe accounts with higher interest rates, however. A number of factors are combining to keep CD rates higher than they'd normally be at a time of such low Fed rates.
"In typical times CD yields are highly correlated with the Fed rate. But these are not typical times," said Greg McBride of Bankrate.com. Because banks are still scrambling to shore up balance sheets, they are doing all they can to attract bank deposits, and competition has helped prop up rates. Top 1-year CD rates have only fallen about 1.5 percent since September of last year, McBride said, while the Fed rate has declined from 5.25 to 1 percent during the same span. Careful shoppers can still find one-year CD rates for around 4 percent, he said.
"Because banks are hungry for deposits, that's keeping a floor under rates," McBride said. He expects CD rates to stay reasonably high for the foreseeable future, even if the Fed funds rate is cut again – to below 1 percent. "The credit crunch isn't going to go away overnight," he said. "... As long as there's a persistent credit crunch that will keep a floor under CD yields."
Ray Montague, manager of deposit customer services for Calabasas, Calif.-based Informa Research Services Inc., isn't quite as optimistic. While high rates are still available to Internet shoppers, average brick-and-mortar CD rates have already fallen to under 3 percent and will probably go lower, he said.
The key, he said, is that many banks are offering aggressive rates for "new money" from new customers. But those who automatically roll over CDs at their local bank without paying close attention can end up with rates just over 2 percent, he said.
Still, Montague doesn't expect the floor to drop out from under savings interest rates.
"It's not doom and gloom or anything," he said. "Regular brick and mortar banks will lower rates 5 to 10 basis points in the next few weeks, that's all." For example, a bank offering a rate of 3.25 today might drop that rate to 3.20 or 3.15.
CD and savings rates won't necessarily plummet immediately following the Fed's decision to lower rates. This rate cut was no surprise, and many banks have already "baked in" the lower rate. But financial advisers say it's critical for savers to shop around.
One tactic many banks use to minimize interest payments to careless consumers, while still attracting savvy consumers, is to offer high rates on "off-cycle" CDs, Montague said. He tells consumers to keep an eye out for 7-month CDs, for example, which often have higher rates.
"My suggestion to consumers is don't let banks automatically roll over CDs. Don't expect the banks to look out for your best interest," he said. "A lot of banks, especially the bigger ones, will not put their most competitive products on their Web site. You have to ask." He also said local bank managers have wiggle room when it comes to rates, so it pays to negotiate. A threat to move your money to a competitor might earn you an extra .10 or .15 percent. "You won't know until you ask," he said.
Help your elderly parents
Children of older parents should be particularly alert right now, said Weston. The elderly, who make up 70 percent of the CD market according to some studies, are unlikely to bargain for better rates or bother to shop around. Talk to elderly parents, she advises, even if it's difficult.
"These conversations can be really tough, especially if you don't talk about money often," she said. "But find a way. Try this: 'Mom and dad, we've been looking at our own situation and made some adjustments. Are you guys OK? We got a great rate on our emergency savings at XYZ bank, how about you?' A little hand-holding can go a long way."
The last time interest rates fell so low, con artists seized on senior citizens' fears of reduced interest income to peddle all manner of scams or unwise financial products, Weston said. She expects the same sort of fear-mongering to occur again.
Those who rely on interest income might be tempted to consider annuities now that CD interest is so meager. But seniors who consider switching from CD savings to annuities -- which promise steady returns -- should carefully consider the choice, she said. Annuities are not appropriate for senior citizens in low tax brackets, and should only be considered by high-net worth individuals who are looking for tax advantages, Weston said.
The irony of the drop in savings interest rates is that the U.S. economy is learning the painful lesson that relying on credit is perilous, and that U.S. consumers really should be saving more money. On the other hand, interest rate policy offers a disincentive for savings right now.
Weston thinks tax policy should be altered to help consumers build up emergency savings.
"It would be so nice to have something simple like a tax credit for savings," she said.
In the meantime, the low Fed rates won't last forever and neither will low CD savings rates. So it's not a good idea to lock up a lot of money in long-term CDs, Weston said. The difference in interest rates between six-month CDs and three-year CDs is negligible. "I wouldn't go too far out because you're not getting compensated for locking your money up," Weston said.
On the other hand, even if the economy recovers or inflation reappears quicker than most economists expect -- and the Fed is forced to raise rates -- don't expect CD or savings rates to recover as quickly.
"What we've seen over and over is rates come up slower than they go down," Montague said. It should be no surprise: Banks will wait to spread the wealth.
RED TAPE WRESTLING TIPS
• Shop around for CD rates. Thanks to the Internet, shopping isn't that hard. For consumers who aren't worried about investing with a Web-based bank, there are many tools for finding the highest national rates, including msnbc.com's easy-to-use site, in partnership with Bankrate.com.
• To find CD rates by region, which will help you find a brick-and-mortar bank to invest with, look at msnbc.com's local CD rate search page by clicking here.