A key way that banks make money is by lending out cash to businesses or to consumers for mortgages and personal loans. The “revenue” banks make is from the interest rate charged on these loans, while most of the “costs” come from the cost of obtaining the money to lend out. To obtain the money, banks often borrow from other banks, and they are charged their own interest rate, called the Federal Funds Rate.

The Federal Funds Rate

The Federal Funds Rate, often referred to as the “overnight rate” or the “Fed rate”, is the rate which banks charge each other for overnight loans. The Federal Reserve sets a target for the Fed rate, and it is a key instrument in the Fed’s monetary policy. Over the past year, the Fed has attempted to combat inflation by increasing the overnight rate. This impacts rising prices due to inflation by increasing the cost of borrowing money, which reduces consumer spending and business investment. This leads to lower overall demand and potentially impacts prices.

Changes in the Fed rate affect the cost of borrowing for banks, which in turn influences their lending standards & practices. In response to a rising Fed rate, banks often implement stricter underwriting standards and higher interest rates due to their increased cost of capital. Due to stricter underwriting standards, some borrowers with legitimate credit needs are turned away from standard bank loans and forced to turn to consumer, which typically have less stringent approval requirements but higher interest rates.

Costs of Consumer Lending

While bank loan interest rates typically follow the Fed rate closely, the Fed rate’s impact on consumer loans isn’t fully straightforward since lenders’ costs of borrowing aren’t solely the Fed rate. Consumer loans, especially subprime, inherently carry more risk for lenders, hence the higher interest rates. Instead, the rising Fed rate pushes more borrowers into the consumer market, increasing demand for capital and enabling lenders to charge higher interest rates (or the “cost of capital”) if they desire.

Looking forward, consensus among economists suggest that the Fed rate might peak within the next twelve months before starting to decline. In this peak and fall scenario, it’s possible that economic conditions could deteriorate as interest rates fall, leading to more financial hardship and consumers living paycheck-to-paycheck. This could result in an increased reliance on alternative lending to make ends meet. For non-bank lenders, this could mean an increase in business, but also an increase in risk due to the deteriorating macroeconomic conditions.

In conclusion, the Federal Reserve’s target for the Fed rate plays a critical role in its monetary policy. The recent efforts to combat inflation through rate increases have had notable impacts on prices, as higher borrowing costs lead to reduced consumer spending and business investments, potentially affecting overall demand and price levels. The rising Fed rate also influences lending practices, causing banks to adopt stricter standards and higher interest rates, resulting in some borrowers seeking alternatives with non-bank lenders. While the relationship between the Fed rate and consumer lending interest is not direct, a potential peak and fall scenario for the Fed rate could lead to increased reliance on subprime lending in the face of deteriorating economic conditions.

The Role of Technology in Consumer Lending

With increased reliance on consumer lending on the horizon, modern lending tools are necessary for lenders to stay competitive. Installmt automates over 50% of payments by purposefully scheduling payments according to the needs of individual borrowers. This alleviates stress on borrowers and helps employees handle the increased loan volume. Installmt has also been able to help lenders cut delinquency rates by 40% by creating custom payment structures for each borrower, which in turn helps reduce late payments paid by borrowers.

Worried about the future rush in demand on your lending business? Schedule a demo to see how Installmt can help.