Posted By: Margaret Pozzini

By ELLEN SIMON, AP Business Writer

NEW YORK - Q: I hear all the time about the Federal Reserve raising or lowering interest rates. How does that affect the rates I pay for my credit card or the rates I see for car loans?
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A: In interest rates, almost everything is relative. With a few exceptions, most rates consumers pay are pegged to other rates, from the Fed's benchmark target rate for overnight loans from one bank to another to the prime lending rate that banks charge their best customers.

The duration of the loan plays a big role. Much of the shorter-term interest you pay is pegged to the most discussed interest rate in the country, the Federal Reserve's federal funds rate, which is the target interest rate for overnight loans from one highly creditworthy bank to another.

The target rate is set during the Fed Open Market Committee's eight regularly scheduled meetings a year; it is called a "target" because actual rates paid are set by the market. The Fed Funds target rate is currently 5.25 percent, but in late October, the "effective" daily Fed Funds rate fluctuated from 5.23 to 5.26 percent, even as the target rate stayed steady, according to Bankrate.com.

The Fed Funds rate is the benchmark banks use to set their "prime lending rate," the rate they charge their best customers. The prime rate is usually 3 percent above the Fed Funds rate, according to Bankrate.com. The current prime rate is 8.25 percent.

The prime rate is important because it is used to set rates for home equity loans and credit cards. The rate consumers pay is always higher than the prime rate, a difference called "the spread." The spread occurs because lenders will only loan money to riskier customers if they're paid extra for that risk.

That spread is determined in part by the consumer's creditworthiness and whether the consumer's loan is secured. Since a bank can repossess your house if you don't pay your home equity loan, you'll pay lower rates on such a loan than you would on an unsecured credit card loan.

When a loan is unsecured, "they can threaten you, they can call you, they can send lawyers after you, but if you don't have any money to give them, you don't have any money to give them," said Keith T. Gumbinger, vice president, HSH Associates, a financial publishing company that tracks mortgages and other loans.

That said, if you have a much better credit rating than your brother, you should also be able to get a credit card with much lower interest payments. Likewise, the U.S. government is more creditworthy than U.S. consumers; while mortgage rates have a correlation to the rates on 10-year Treasury bonds, mortgage rates are always higher.

Supply and demand also play a role on some interest rates, such as those for mortgages and car loans. When demand for something drops off, rates can fall with it. The zero percent financing announced in October by Ford Motor Co. and DaimlerChrysler AG's Chrysler Group had little to do with broad interest rates and everything to do with falling demand for the companies' cars.

Longer term interest rates tend to track longer-term securities. (See http://library.hsh.com/?row_id90 for a look at how mortgage rates have not tracked short-term Fed Funds rates.)

One reason why mortgage rates are correlated with 10-year Treasury bills is that few mortgages last their entire 30-year duration: Most people are likely to move or refinance their loan within ten years.

Another link between the two: The same investors who buy 10-year Treasury bills are apt to buy bundles of mortgages traded as interest-bearing mortgage-backed-securities. Investors expect a higher yield on these securities than they would get on Treasury bills, because just as you may have better credit than your brother, the U.S. government has better credit than U.S. consumers.

"The spread reflects the fact that while the government will not default on its obligations, some home borrowers may," said Greg McBride, senior financial analyst, Bankrate.com.

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