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What Is the Federal Funds Rate and How Does it Impact You?
What Is the Federal Funds Rate and How Does it Impact You?
When you take out a loan, open a new credit card, or contribute money to a savings account, one of the first things you want to know is the rate on those products. With loans and credit cards, lower rates work in your favor. But with savings accounts, higher rates could mean higher earnings.
But how do the banks and lenders you work with set the rates they charge? In most cases, they base their decision on the federal funds rate—the rate set by the Federal Reserve Open Market Committee.
The federal funds rate has a big impact on many of the financial products you use. Let’s look at what the rate is, how it’s set, and how it impacts your finances.
Key Takeaways
• The federal funds rate refers to the rate set by the Federal Reserve Open Market Committee. • The rate determines how much banks charge when lending money to other financial institutions overnight. • The federal funds rate doesn’t directly determine rates borrowers and savers receive, but it does influence them.
What Is the Federal Funds Rate?
The federal funds rate is what financial institutions charge when they borrow money from each other overnight. Though the rate technically only applies to banks and financial institutions, it often influences the Annual Percentage Rates (APRs) you pay as a borrower and the Annual Percentage Yields (APYs) you receive on savings products.
This is because the federal funds rate influences a bank’s lending costs. When the fed lowers the rate, it’s cheaper for banks to borrow from each other, and they pass those savings on to borrowers in the form of lower APRs on loans. They also tend to reduce APYs on savings products because they aren’t making as much when lending money to other banks, so they lower rates to maintain their profitability. When rates rise, the opposite occurs; APRs on loans rise because borrowing is more expensive and APYs on savings products rise because banks are making more money when lending out money.
The federal funds rate itself is typically expressed as a range with a minimum and maximum amount that banks may charge each other.1
How the Fed Sets the Federal Funds Rate
The Federal Reserve (the Fed) is the central bank of the United States and is in charge of making and enforcing monetary policies and regulations. The Federal Open Market Committee (FOMC), which is part of the Fed, is the body that sets the rate.
When Does the Fed Adjust Rates?
The federal funds rate may change throughout the year, but to initiate those changes, the FOMC must meet and consider the condition of the economy and how the rate may impact current monetary policies.
The FOMC holds these meetings eight times a year, typically twice per quarter.2 Some meetings result in a rate increase or decrease, while others result in the rate staying exactly the same. The FOMC’s actions ultimately depend on the economic conditions at the time of the meeting, which is why rates could change several times throughout a given year. 3
Unfortunately, there’s no reliable way to predict what the FOMC will decide to implement, even though economists (and armchair economists) love trying to predict!
Why Does the Fed Adjust the Rate?
The Fed adjusts the federal funds rate to support steady economic health, and when the economy is stable, the rate is typically stable… meaning that the FOMC doesn’t have much incentive to move the rate.
During periods of high growth, the FOMC may move the rate higher to help deter or curb inflation. Basically, this action makes it more expensive for banks to borrow money from each other and helps control the flow of money in the economy.
When the economy is stagnant or declining in growth, the Fed typically sets the rate low to help encourage lending, spending, and economic expansion. This action makes it cheaper for banks to borrow from one another, and they tend to pass those savings onto borrowers. The objective would be to encourage an increase in consumer spending and to inject more money into the economy.
How the Federal Funds Rate Impacts Consumers
The FMOC does not directly dictate rates for consumers, but the fed funds rate usually does have a trickle-down effect for consumers. The impact it has depends on whether you’re borrowing money or building your savings.
Impact on Borrowers
We’ve already established that the federal funds rate may impact how much it costs consumers to borrow money. When the federal funds rate is set higher, the rate lenders charge is typically higher as well—on products such as car loans, mortgages, credit cards, etc.
It stands to reason that if the cost of borrowing money to buy a car or a home is high, you may reconsider making that purchase. Therefore, when rates are high, consumers tend to put off bigger purchases and parts of the economy may slow down as a result.
When you also consider how much businesses need to borrow—for equipment, facility space, even to cover payroll in slow months—then it makes sense that when rates for them are high, they may slow down their growth as well.
When the federal funds rate is low or dropping, the rates that borrowers pay on loans and credit cards may be lower as well. As a result, a consumer may find they can afford to finance a purchase. Same would be true for a business. Consumer purchasing and business expansion usually spur growth in the overall economy.
Bear in mind that changes in the federal funds rate don’t impact existing fixed-rate loans. Those rates are locked in. But for those who have debt with a variable-rate, their rates may change throughout the repayment term.
Impact on Savers
For savers, the federal funds rate may impact how much interest they earn on their savings. When the federal funds rate is high, the APY offered on deposits is typically higher as well, which tends to encourage consumers to save.
It follows that if the earnings on savings is attractive, you may choose to save more rather than spend. Products like high-yield savings accounts (HYSAs) could make your earnings even higher because those accounts tend to offer the most favorable rates. But if your money is in the bank (literally), you’re probably not making as many purchases and fueling the economy.
When you also consider how much businesses earn on their cash reserves, higher savings rates might incentivize them to save too.
When the federal funds rate is low or dropping, earnings for savers may also decline. As a result, consumers may feel less inclined to save and more motivated to spend or invest elsewhere. The same is true for businesses, which may focus on growth rather than holding onto cash. Increased spending and investments generally stimulate the economy.
Keep in mind that if you have savings in a fixed-rate deposit account, such as a certificates of deposit, your rate won’t be affected by changes in the fed funds rates during the term of that specific account.
Banks Set Consumer Rates
While the federal funds rate influences the rates that banks offer consumers, banks still set their own rates on their products.
It’s also worth noting that if you’re borrowing money, the rate you’re offered on a loan could depend on several other factors too, including:
Your credit score
Your income
Your credit history
For savings rates, banks may have a variety of criteria too: for example, there may be tiered rates depending on an account’s balance.
Ultimately, do your research when shopping for a banking products and always read the fine print!
How to Use Rate Changes to Your Advantage
As mentioned, since financial institutions are ultimately in charge of the rates they offer, you may consider switching banks to be able to get a more favorable rate.
For savings accounts or other deposit products, take a look at HYSAs because they tend to have the highest rates in the marketplace. But as you shop around, be wary of jumping to a fintech—they may not have FDIC insurance on their deposits. Safety is important in every rate environment!
If you’re considering taking out a new personal loan or credit card, research multiple banks and credit card companies.4 Compare the rates they offer and the size of the loan or credit limit they’re willing to extend.
Final Thoughts
The federal funds rate influences the rates that banks, lenders, and other financial institutions offer on loans, credit cards, and savings products. But it’s only a guide.
Since the federal funds rate doesn’t limit what rates banks may offer to consumers, it’s important to compare your options when looking for a lender or a place to keep your savings.
If you’re looking for a high-yield savings account to help you grow your savings over time, look for one that offers competitive rates and convenient management, like Jenius Savings!