Where can I get in on this zero-interest action?

Last week's move by the Federal Reserve to let a key interest rate fall to as low as zero has lots of readers asking: Where can I get some of this zero-percent financing? 

If the prime interest rate is at near zero percent shouldn't my interest go down on my credit cards? The fee is supposed to be "prime plus 5 percent" or 6 percent or whatever percent.
Carol, Fort Myers, Fla.

The prime rate did indeed drop following the Fed’s announcement last week that it was letting the short-term federal funds rate fall to zero. But that fed funds rate applies only to banks lending money to each other overnight. The prime rate — originally reserved by banks for their best (or “prime”) business customers — is typically about 3 percentage points higher than the Fed funds rate. That "spread" is how banks make their money.

Banks set their prime rate wherever they choose. To stay competitive, most of them closely track moves by the Federal Reserve — but there’s no requirement that they do so. Because many consumer loans are now tied to the prime, some nonbank lenders use the average prime rate as the floor for their loans; the added interest represents their spread. One widely followed benchmark is printed daily in the Wall Street Journal, whose editors say it represents the rate that three-quarters of the nation’s 30 largest banks are charging.

Last week, the prime rate at most banks fell to 3.25 percent from 4.0 percent. (The extra quarter-percentage point represents the upper end of the Fed’s “zero to one-quarter percent” target range for overnight lending.)

So if you’ve got a credit card with an adjustable rate that’s “prime plus 5” you should be paying 8.25 percent interest. If it’s higher, give the card company a call and ask why.

Credit card lenders can — and do — raise the rate they originally agreed to if your credit profile changes. In some cases, card companies have been raising rates and cutting credit limits with little or no notice. Unfortunately, if you read the original terms carefully enough, you will see most credit card issuers have the right to change the terms of your agreement at will. Your recourse is to close the account, which isn’t all that easy if you’re running a high balance.

One more reason to pay the thing down every month.

Now that it is cheaper for banks to borrow short-term money, why don't the banks lower their mortgage interest rates to, say, 3 percent to folks who need a mortgage?
Grace, Pittsburgh, Penn.

The reason is that mortgages are long-term loans, not short-term. The short-term rate the Fed typically controls applies on only to the rate banks charge to lend to each other overnight.

So why would a bank lend money overnight in the first place? The reason is that banks have to have a minimum level of reserves on their books — set by the Fed — at the close of business every day. If Bank A makes a few extra loans and its reserves dip below the minimum, it has to borrow a little cash from Bank B that took in a little more in deposits to keep it above that level. The next day, the money moves back to Bank B and Bank A pays a little interest for the use of the money. When you’re moving billions of dollars back and forth, that little interest adds up.

In normal times, the Fed controls that short-term rate by moving billions of dollars of cash in and out of the financial system. Pump in a little more, and more banks have money to lend, so rates dip a bit. Take money out of the system, and rates tighten up. The Fed’s open market desk in New York buys and sells Treasuries to make this happen.

These, however, are not normal times. The global markets are in such a panic that banks, investors, pension funds, governments — anyone with large pools of money to manage — have been flocking to short-term investments like U.S. Treasuries. That flood of cash has overwhelmed the Fed’s efforts to manage short-term rates, pushing them to zero.

But lenders who make long-term loans like mortgages don’t use short-term rates. Not if they want to be in business for the long-term. Consider for a minute what would happen if a mortgage lender borrowed short-term money today at, say .25 percent, and lent it out for 30 years. Since interest rates are almost certainly going to rise in the next 30 years, that mortgage lender would lose money. It’s not a lot different than you buying a 30-year CD (if they were available) at 0.25 percent — only to lock in your savings at a subpar return rate for a lifetime.

Mortgages lenders get their money from investors who demand higher rates to compensate them for the likelihood that rates will go up in the next 30 years. So last week, the Fed said it’s going to try to cut long-term rates, too — a move that’s never been tried before.

The plan involves buying up long-term Treasury bonds in such massive quantities that the rates on those securities are pushed lower. (Demand for bonds pushes up their price; when prices rise, the rate falls.)

The hope is that if the average return on long-term Treasury bonds is pushed lower, investors will have to look elsewhere to get a decent return on their investment. With the government backing Fannie Mae and Freddie Mac, loans managed and sold by those mortgage agencies are almost as safe as Treasuries. If all goes well, that should push mortgage rates down along with Treasuries, helping to get the battered housing market back on its feet.

Just the word that the Fed is moving in this direction has already had an impact. By the end of the week, 30-year mortgage rates had dropped as low as 5 percent — the lowest in 37 years.

Unfortunately, those lower rates won’t help the millions of homeowners facing foreclosure who are stuck in unaffordable loans with onerous “pre-payment penalties” — sometimes as much as half a year’s interest payments. Without additional government relief, those homes will likely get dumped on an already glutted market, pushing the housing recovery into 2010 at the earliest.