Why does the Fed adjust interest rates?
The Fed uses the federal funds rate as a tool for promoting national economic goals. When the economy shows signs of slowing down, the Fed typically lowers interest rates.2 This ultimately helps incentivize individuals and businesses to spend more because the cost of borrowing money is lowered. This process helps propel growth.
On the other hand, when the economy appears to be growing too quickly, the Fed can choose to raise interest rates. This helps to slow spending and helps prevent rapid inflation.
Changes to the federal funds rate don't directly impact the interest rate you'll pay on your credit card, mortgage, or other debt. However, they do trigger a chain of events that affects consumers in several ways.
What changes in the federal reserve interest rate mean for you
One of the ripple effects of a change in the federal funds rate is that prime rates change along with it. The prime rate is the rate that a bank offers to its least risky customers. Each bank sets its own prime rate, which is usually a few percentage points above the federal funds rate. For example, in March 2020, the effective federal funds rate was 0.25%, while prime was 3.25.3
The interest rates for some types of debt (such as credit cards, bank loans, and home equity lines of credit) are based on the prime rate, so those interest rates go up or down alongside it. Other types of debt (such as mortgages and home equity loans) have a looser connection to the prime rate, so their rates remain relatively stable.
Here's how changes in the federal funds rate can impact different kinds of debt payments.
Banks generally use prime as the starting point from which to calculate the interest rate on loans. The average customer can usually count on their bank adding a few percentage points to the current prime rate — more if they're a riskier borrower with less than stellar credit.
If you have an existing bank loan with a fixed interest rate, changes to the federal fund rate won't impact your cost of borrowing. However, if you have a personal loan or line of credit with a variable interest rate based on prime, changes in the Fed's interest rate will impact your loan or line of credit at the next adjustment period.
The Fed's changes to interest rates do have some impact on mortgage rates. However, mortgage rates are also influenced by other factors, such as inflation, job creation, the overall health of the economy, and long-term bond rates.
About 90% of mortgages are fixed-rate loans. If your mortgage has a fixed interest rate, changes in the federal funds rate won't have any effect. Likewise if you have a home equity loan, because these are usually fixed-rate as well.
However, if you have an adjustable-rate mortgage (ARM), changes to the federal funds rate could have an impact eventually. When interest rates are low, you could see the rate on your ARM drop at the next adjustment period.
Home equity lines of credit also have adjustable rates that are based on prime. As such, they tend to go up or down along with the federal funds rate. The interest rates on some HELOCs may adjust monthly, while others might offer interest rate locks for a longer period of time.
If you're currently in the middle of buying a home or refinancing your existing mortgage, you might not see an immediate change in rates following a Fed announcement. However, homeowners who are considering refinancing should follow mortgage rates closely. When the difference between the rate on your mortgage and the current mortgage rate is big enough, it can make sense to refinance. This refinance calculator can help you decide.
The interest rates on credit cards are also based on the prime rate, but you probably won't see an interest rate on a credit card anywhere near that low. That's because banks base credit card rates on prime plus another margin they set themselves.
For example, even though the prime rate was 3.25% for the week of March 25, 2020, the average credit card interest rate was 16.69%.4 Still, when the federal funds rate goes down, you can expect to see lower interest rates from your credit card issuer.
When the Federal Reserve announces changes to interest rates, it has a ripple effect. If you carry a balance on your credit card, have a HELOC or ARM, or plan to refinance soon, it's a good idea to pay attention to those Fed interest rate announcements.