What Is The Federal Funds Rate And How Does It Affect You?
If you want to buy a home and are concerned about getting a loan you can afford, you’ll want to understand how mortgage rates are determined. One of the primary factors is the federal funds rate. Policymakers at the Federal Reserve have influence over the federal funds rate, which affects what banks must pay to borrow money. That affects the rates banks must set to earn a profit on mortgages and other lines of credit they offer to consumers.
Key Takeaways:
- The Federal Open Market Committee has influence over the federal funds rate – a benchmark interest rate that’s used for overnight lending between banks.
- As the United States’ central interest rate, the federal funds rate influences rates for many types of loans, including your mortgage.
- The Fed adjusts the federal funds target rate based on economic conditions, lowering it to spur spending and raising it to curb inflation.
The Federal Funds Rate Explained
The federal funds rate is the interest rate banks use when they borrow money from each other overnight to make sure they have enough liquidity on hand.
Contrary to popular belief, the Federal Reserve doesn’t actually set this rate. The individual rates are negotiated between the lenders when they borrow from each other. The Federal Reserve, as the central bank of the United States, can only influence this rate, which it typically does by altering its own patterns of debt purchasing.
The term federal funds rate can refer to two different things: the federal funds target rate and the effective federal funds rate.
Federal Funds Target Rate
The Federal Open Market Committee, a branch of the Federal Reserve, sets the federal funds target rate. The target rate has a range of 0.25%. For example, the current federal funds rate target is 4.5% to 4.75%.
Effective Federal Funds Rate
The effective federal funds rate is a volume-weighted median of the interest rates banks charge each other for overnight loans. The Fed will use various tools to influence the EFFR, so it’s within the federal funds target rate.
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How Does The Federal Reserve Affect The Federal Funds Rate?
The FOMC has 12 members. Seven of the seats are held by members of the Federal Reserve System’s board of governors, one seat is held by the president of the Federal Reserve Bank of New York, and four seats are held by the presidents of the remaining 11 Federal Reserve Banks, who serve rotating, one-year terms.
The FOMC meets eight times each year. At each meeting, the committee decides whether to maintain, raise or lower the federal funds target rate. The Fed then tries to steer the effective federal funds rate to fall within the target rate range. The primary tool it uses is the interest rate on reserve balances.
Banks can deposit their reserve funds with the Federal Reserve risk-free. By adjusting the interest rate banks earn on these deposits, the Fed affects the rates offered for other overnight loans. Raising this rate forces banks to pay higher rates while lowering it allows them to reduce their rates.
The Fed also influences the EFFR through open market operations, which involve buying and selling securities on the open market. By buying securities, the Fed can increase the money supply in the economy, which reduces demand for loans and lowers interest rates. Selling securities reduces the money supply, boosting demand for loans and interest rates.
Fed Funds Rate Vs. Discount Rate
The discount rate is the interest rate the Federal Reserve charges to lend money to banks that are having trouble meeting their minimum reserve requirements. It effectively serves as a ceiling for the federal funds rate since banks are unlikely to borrow from each other at a higher rate than they could get from the Federal Reserve.
Fed Funds Rate Vs. Interest Rates
The federal funds rate is used specifically for overnight loans between banks. Other types of loans will have their own interest rates. However, the federal funds rate does impact the rates for other loans, such as mortgages.
Fed Funds Rate Vs. Prime Rate
The lowest rate a bank will offer its most creditworthy customers is called the prime rate. Every other rate offered is based on the prime rate, which is typically a few percentage points higher than the federal funds rate. Some loan products with variable interest rates, such as credit cards, may have rates quoted as the prime rate plus a set percentage, depending on other factors specific to the borrower.
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A History Of Federal Funds Rates
The federal funds rate has fluctuated dramatically, based on how the FOMC set policy to manage the economy.
Until very recently, the federal funds rate had an extended period of being relatively low. The FOMC cut it to nearly zero percent in the wake of the 2008 financial crisis, and it stayed at that level for almost a decade. The rate slowly increased, peaking at 2.42% in 2019 before being cut to near zero percent again due to the economic effects of the COVID-19 pandemic. Recently, inflation caused a quick increase in the rate to 5.33%.
Before the 2008 financial crisis, the federal funds rate fluctuated between 2.5% and 7.5%. The federal funds rate peaked at just over 19% in the early 1980s. This was due to historically high inflation, which remained above 6% between 1977 and 1982, reaching an annual rate of 13.5% in 1980.
Why Does The Federal Reserve Change Interest Rates?
The Federal Reserve’s policy changes are based on macroeconomic conditions at any given moment. The Fed talks about what it tracks in its statement at the end of every meeting.
“The Fed uses rate changes to control inflation and maintain healthy unemployment rates,” says R.J. Weiss, a Certified Financial Planner and Founder of personal finance website The Ways To Wealth in Geneva, Illinois. “When they cut rates, borrowing can increase, promoting economic and job growth. When they raise rates, they’re trying to keep the economy from growing too fast, which can cause inflation.”
Among the key things the Fed tracks are employment, spending, actual inflation and expectations. Inflation expectations can be as important as what’s happening because if consumers expect prices to keep rising, they’ll spend now, which can actually cause prices to increase because it keeps demand at a high level.
Beyond data points, the Federal Reserve also looks at current events and how they affect markets. For example, in 2022, the Russian invasion of Ukraine led to sanctions on Russian oil, which in turn led to higher gas prices because of decreased supply.
To Respond To A Recession
When the Federal Reserve senses the economy slowing down, it usually acts to prevent or lessen the pain associated with a recession.
The most recent example was the Fed’s actions at the beginning of the COVID-19 pandemic. To stimulate the economy and encourage buying, it slashed the federal funds target rate to near zero percent. The other action involved buying large amounts of agency mortgage-backed securities and Treasury securities to help the market run smoothly.
To Reduce Inflation
In 2024, the economy is in the opposite situation, with signs that it may have expanded too quickly. In addition to the actions of the Fed, one of the other things the government did to help people during the pandemic was three rounds of stimulus checks for qualifying Americans. It helped, but combined with higher oil prices and supply chain issues, prices in general have risen.
To bring inflation under control, the Federal Reserve began to raise the target on the federal funds rate. In addition, it’s reduced the size of its Treasury securities and agency MBS holdings, which it purchased at the beginning of the pandemic, indirectly causing interest rates to rise further. This encourages people to hold on to their money rather than spend it, which, in theory, should cool inflation.
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How Does The Federal Funds Rate Affect Mortgages?
The federal funds rate is the interest rate banks can earn for one of the lowest-risk loans: overnight loans to other banks. That means it also affects the interest rates for other loans, including mortgages. After all, if a bank could earn a baseline of 5% interest by loaning to other banks, why would it offer the same relatively low rate on a riskier loan, like a mortgage?
When the FOMC sets a new federal funds rate target, it acts to move the EFFR into the new target range. That affects the interest rates of mortgages. If the target rate and EFFR rise, mortgages get more expensive. If they fall, mortgages get cheaper.
“When the federal funds rate increases, it becomes more expensive for banks to borrow,” Weiss says. “To maintain profitability, banks then increase mortgage rates to consumers, as their costs have also increased.”
If you already have a fixed-rate mortgage, your rate will remain unchanged despite fluctuations in federal funds. However, if you have an adjustable-rate mortgage, changes in the EFFR will likely cause a change in your loan’s rate when it next adjusts.
How Does The Federal Funds Rate Affect Other Loan Types?
Here’s how the federal funds rate influences different types of loans besides mortgages.
Home Equity Loans
The federal funds rate affects home equity loans similarly to mortgages. Home equity loan rates rise when the federal funds rate increases and fall when it decreases. If you already have a fixed-rate home equity loan, your rate will not change, but new home equity loans – as well as variable home equity lines of credit, or HELOCs – will see rates change quickly.
Credit Cards
Credit cards can be a riskier form of lending because the debt is unsecured, meaning there’s nothing for the lender to take back if you default. For this reason, and the fact that the balance is constantly changing based on new payments and purchases, credit cards have some of the highest interest rates you can get.
Credit card interest rates go up or down almost instantly based on short-term interest rate changes like those of the federal funds target rate. Because of the generally higher rates, if you’re not in the habit of routinely paying off your balance, this could lead to unmanageable debt for borrowers.
Personal Loans
A personal loan is an unsecured loan that’s given based on factors including your credit profile and income. However, unlike a credit card, it usually comes with a fixed rate and is paid off over a set term. Rates for this type of loan are still higher than secured loans backed by some kind of property, but they usually have lower rates than credit cards.
As with any type of loan, monetary policy also plays a role in the interest rate of your personal loan. The higher the federal funds rate, the higher the interest rate on your personal loan.
Auto Loans
Auto loans are certainly still impacted by changes in the target for the federal funds rate, but it’s less of a one-to-one correlation because the rates are longer-term and further removed from the day-to-day funding needs of banks.
Auto loans also tend to offer lower rates than you could get with a personal loan or credit card because of the key differences between secured and unsecured loans. Since secured loans are backed up by property, such as your car or home, they’re less risky for lenders and come with lower rates.
The downside is if you don’t make the payments, a lender can take your car or initiate foreclosure on your house. If you think you’ll have trouble making your payments, it’s important to contact your servicer immediately.
FAQ
Here are answers to some frequently asked questions about the federal funds rate.
The Bottom Line
The Federal Reserve has a great deal of influence over interest rates. However, it doesn’t actually set rates beyond the Fed discount rate that lenders are charged to borrow directly from the Federal Reserve. The federal funds rate is complicated and has a significant impact on the entire American economy. Understanding what impacts the rate and how it can affect you can help you prepare for changes in the benchmark rate.
If you’re looking to buy a home or refinance your current mortgage, it’s important to pay attention to the direction of interest rates because it affects your budget and the type of loan that will help you accomplish your financial goals.
T.J. Porter contributed to the reporting of this article.
