What is the Federal Funds Rate?

What is the Federal Reserve?

The Federal Reserve (aka “the Fed") is the central banking system of the U.S. Its purpose is to keep the country's financial system stable1 and help keep the economy healthy. One of the ways it does that is by setting what's known as the federal funds rate. The federal funds rate is the interest rate at which banks borrow and lend money to each other, usually on an overnight basis.

All banks are required to hold a certain percentage of their customers' money at a national reserve bank, where the money doesn't earn interest. If a bank doesn't have enough money in reserve, it can get an overnight loan2 from another bank. The bank lending the money earns a rate of interest that is based on the federal funds rate.

Why does the Fed raise and lower rates?

When the economy shows signs of slowing down, the Fed typically lowers the federal funds rate. When the overnight rates are lower, banks are more likely to lend money to businesses and individuals — and lend it at a lower interest rate. This incentivizes businesses to invest and hire more. It also encourages consumers to spend money, which helps propel growth.

On the other hand, sometimes the economy looks like it might be growing too quickly, which can lead to rapid inflation and big increases in the prices of goods and services. In this case, the Fed may decide to increase the federal funds rate. This causes banks to tighten their lending requirements and increase the interest rate on loans they make. This, in turn, causes businesses and consumers to slow down on spending.

The Federal Open Market Committee (FOMC) is the Fed's committee that makes decisions about interest rates. The FOMC may change the federal funds rate at one of their eight regularly scheduled meetings3 throughout the year. However, if circumstances call for a change in interest rates between these regular meetings, the FOMC may hold an emergency meeting to raise or lower rates.

How the federal funds rate impacts you

While the federal funds rate does affect the cost of borrowing money, the connection isn't as direct as you might think. Here's an overview of how changes to the federal funds rate may impact you.

Credit card rates

Interest rates on most revolving debt, including credit cards, aren't tied directly to the federal funds rate. Instead, they're based on the prime rate.

Prime 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 points4 above the federal funds rate. For example, if the federal funds rate is 1.5%, a bank's prime rate might be 4.5%.

Of course, most people don't see rates that low on their credit card. That's because credit card issuers charge the prime rate plus another margin that they set themselves. Still, when the federal funds rate goes down, that typically affects the prime rate, which in turn influences credit card interest rates.

Mortgages

The federal funds rate does influence mortgage rates, but the two aren't directly linked.

After each regularly scheduled meeting, the FOMC issues a press release to the public, highlighting the committee's economic opinions. If the press release is generally positive on the U.S. economy, mortgage rates tend to rise.5 This is because there's less concern among home buyers about jobs and inflation, so they're more likely to buy homes. On the other hand, when the Fed's outlook is negative, mortgage rates tend to fall, as banks hope that offering lower rates will spur home buying. So while the Fed doesn't directly impact mortgage rates, it does give some economic guidance6 to mortgage markets.

Several other elements have an impact on mortgage rates, including inflation, job creation, the overall health of the economy, and long-term bond rates.

Home equity loans

One area of home lending that is more directly tied to the federal funds rate is home equity lines of credit. HELOCs are adjustable-rate loans based on the prime rate7, and prime rates closely track the federal funds rate. When the federal funds rate goes up or down, HELOC rates tend to go up or down with it.

Auto loans

The federal funds rate doesn't have a significant impact on auto loans. Auto loans are typically fixed-rate loans, and their interest rates tend to remain low, even during years with rate hikes. That's because automakers and dealerships use low interest rates as a way to entice buyers.8

Student loans

Many student loan borrowers rely on federal student loans, which have fixed rates.9 However, private student loans may have fixed or variable rates. Fixed rate student loans have rates that are tied to the prime rate at the time that the loan was created. Variable rate loans have interest rates that are adjusted periodically (often annually, though it could be more or less often).10 Every time a variable rate loan has an interest rate adjustment, the new interest rate is tied to the prime rate. When the Fed lowers the federal funds rate, borrowers may pay less in interest if they have a variable rate loan, depending on when their interest rate is adjusted.

Savings accounts

Banks tend to pay savings account owners less when the federal funds rate goes down and more when the federal fund rate goes up. This is because when banks earn less on overnight loans to other banks, they lower the amount they pay account holders to protect their profits.11 However, the impact usually doesn't happen right away.

The interest rate on savings accounts has more to do with how much banks want customers to deposit their extra cash, giving the bank more money to make loans.

Whether it goes up or down, a change to the federal funds rate tends to have a ripple effect for borrowers and savers. That's why it's a good idea to keep an eye on interest rate changes, especially if you plan on making a big purchase or refinancing your home in the near future.