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The central bank of the U.S., also known as the Federal Reserve, is responsible for maintaining economic and financial stability. It’s a complex institution, and it has a huge influence on your wallet. The Federal Reserve (sometimes referred to as the Fed) is known for keeping the economy afloat by raising or lowering the cost of borrowing money, or in other words, interest rates.
On March 16, 2022, the Fed announced — after 2 years of keeping them at 0% because of the COVID-19 pandemic — that it would raise interest rates by 0.25% (up 25 basis points). The Federal Open Market Committee (FOMC) also has predicted a federal funds rate of 1.9% by the end of 2022, which means rates would rise 6 more times this year, following each of the committee’s remaining meetings.
Officials of the rate-setting committee are tasked with making these decisions, and they look at a variety of economic factors, mostly to analyze what’s happening with employment and inflation. With inflation being much higher than the central bank’s target, the Fed is again expected to raise the federal funds rate multiple times throughout the year.
And, it’s hard to ignore these changes since the federal funds rate doesn’t just impact larger financial institutions. Consumers are also affected since rates on credit cards, savings accounts, and different kinds of loans fluctuate when the Fed changes its benchmark rate. This domino effect can reach the finances of everyday citizens. Here’s what you need to know.
What is the federal funds rate?
The federal funds rate is one of the most important economic indicators globally, and its significance is not only financial, but psychological as well. Investors, borrowers, and any person that uses money start to think about their finances differently as rates begin to fluctuate. All depository institutions, such as banks or credit unions, were once required by law to keep a certain amount of cash on hand each night, so people were able to withdraw money.
That amount was called their reserve requirement, and it was based on a percentage of the total amount of money that people deposited. If a bank’s cash reserve fell under that amount, one bank would borrow funds from another in order to meet that requirement. The interest rate banks would charge one another on these loans was known as the federal funds rate. However, in March 2020, the Federal Reserve’s Board reduced the reserve requirement ratios to zero, meaning there’s no requirement at this time.
Here’s a look at this intricate system that determines federal interest rates and how the trend of higher rates impacts your overall finances.
Federal funds rate definition
The federal funds rate is the target interest rate set by the Federal Reserve that banks use for overnight lending. The FOMC within the Federal Reserve meets 8 times a year to determine the target range.
From March 2020 to March 2022, in response to the pandemic, the target range had been set to 0% to 0.25%. The target range for the federal funds rate that the FOMC sets acts as a reference for the interest rates big banks charge each other for overnight loans.
How does the Federal Reserve affect everyday interest rates?
The federal funds rate affects how much banks pay to borrow and lend, so it impacts how much they will charge you for their financial products, causing a ripple effect on other interest rates you might use in daily life. That’s what makes the federal funds rate a useful tool for the Federal Reserve when it comes to influencing the stability of the U.S. economy.
The Fed’s number one job is to manage monetary policy for the U.S., which means controlling the flow of money in this country’s economy. While the Fed has various tools to get this job done, its ability to influence interest rates is its leading and most effective one.
Financial institutions base their interest rates for consumers on the Fed’s rate and offer their lowest-risk customers a prime rate. This rate is usually 3 percentage points higher than the federal funds rate and is the best possible interest rate you can obtain when you borrow money with a good credit score.
When the federal funds rate changes, it affects consumer interest rates, such as the rates for home equity lines of credit, credit cards, and auto loans. Due to this arrangement, the federal funds rate is the most influential benchmark for interest rates within the U.S. economy and even influences interest rates throughout the global economy as a whole.
Look out for Federal Reserve rate hikes
A rate hike essentially means an interest rate is increasing, which makes borrowing money more expensive, and the cost of doing business rises for companies and businesses. Keeping tabs on the Federal Reserve’s monetary policy changes is an important part of keeping your personal finances in order, since these adjustments affect consumer spending too.
As an individual consumer — or even a business owner — it’s important to know what this movement means when it comes to a federal rate hike and how it can influence your personal financial circumstances.
What does a high federal funds rate mean?
A higher federal funds rate can have both positive and negative effects, depending on whether you’re trying to borrow or save money. Changes in interest rates might even dictate whether you can afford bigger life purchases, such as a home, a car, or even college tuition.
When the Fed raises the federal funds target rate, the intention is to increase the cost of credit throughout the economy. Higher interest rates make loans more expensive for both businesses and consumers, resulting in everyone spending more on interest payments. People who can’t or don’t want to deal with higher payments may put a hold on projects that involve financing during this time.
This entire process reduces the supply of money in circulation, which works to lower inflation and stabilize economic activity. In the past the money supply has gone down when the Federal Reserve raises banks’ reserve requirements, which resulted in them lending out less money. Rising interest rates inevitably impact mortgages, stocks, bonds, credit cards, personal loans, student loans, auto loans, and business loans.
You might pay more for debt
Borrowing can become more expensive when the federal funds rate is raised, so if you’ve been thinking about refinancing a debt, the best time to do it is when the rate is still low. The amount you pay toward credit cards and loans with a variable rate will most likely increase as the federal funds rate increases, costing you more money. And, it could even become more expensive to take out new loans with fixed interest rates. So if you’re considering taking out a new loan or mortgage, consider trying to lock that in now, too.
Still, with more rate hikes planned for later this year, it’s probably not a bad idea to try to put your extra funds toward your debt now, if you can. You can work to pay off high-interest credit cards if you’re carrying balances, since it will cost you more when interest rates go up. A good method for paying down credit card debt is to target the balance with the highest interest rate first, which is known as the debt avalanche method.
You might earn more on savings
On the other hand, rising interest rates are ideal for your savings account because higher rates may earn you more money. Since many savings accounts’ interest rates are closely tied to the target federal funds rate, you may see a little more in your account(s). It may even be more encouraging to save money during this time to potentially earn more with these higher rates through compound interest. Local banks and credit unions can offer some of the most competitive rates when it comes to savings accounts, along with online financial institutions.
Why do Feds lower interest rates?
During times of financial crisis, the Fed will lower interest rates. Lower interest rates mean cheaper loans, which results in more spending to help the financial markets recover. More spending also tends to stimulate inflation, so the Fed also keeps an eye on inflation numbers. The Fed manages an annual inflation target of 2%, where products and services become 2% more expensive year over year.
A lower federal funds rate also encourages banks to lend more to consumers because they make more money from these loans than from lending money to each other. To help appeal to borrowers, the bank will lower interest rates. You can take advantage of lower interest rates to improve your financial situation, and you might consider making some of these moves when rates are low:
- Buying a house or car
- Refinancing your mortgage
- Refinancing personal or student loans
- Consolidating debts
When do interest rate changes take effect?
The federal funds rate is changed and takes effect the day the committee sets the new target range. So, for example, at the last meeting in March, those rates were put into place that day.
However, it’s important to know that there is usually a 12-month lag in the economy, meaning that it takes at least 12 months for the effects of any increase or decrease in the federal funds rate to be felt or noticed by the everyday consumer.
What’s the interest rate on federal student loans?
The current interest rate on federal student loans is temporarily set to 0%, which, at the time of publishing, is expected to last through May 1, 2022. The U.S. Department of Education extended the emergency relief for student loans in December 2021. The relief for eligible student loans includes:
- A suspension of loan payments
- A 0% interest rate
- Stopped collections on defaulted loans
However, following this deadline, the interest rate for undergraduate student loans is expected to return to 3.73%, up from 2.75% in 2021.
Do Fed rates impact mortgage rates?
The federal funds rate affects loans, such as credit cards and mortgages with adjustment rates. Unlike conventional fixed-rate mortgages, ones that are adjusted have a floating interest rate that goes up and down with the market every month. However, long-term rates for fixed-rate mortgages are typically not affected by any changes made to the federal funds rate.
How do federal interest rates affect the stock market?
A higher federal interest rate can have a negative impact on the stock market. When federal rate hikes occur, it makes borrowing money become more expensive, which causes the cost of doing business to go up for public and private companies. Elevated costs and less business can result in lower earnings for companies, which can impact their stock values.
These increased rates also have an immediate impact on market psychology and can change the way investors feel about the stock market. When the FOMC announces a rate hike, it’s common for investors to sell their stocks and move to more conservative investments, so they don’t have to wait out the process of higher rates working their way through the economy.
What’s the federal short-term interest rate?
The federal short-term rate is determined by a one-month average of the market yields with maturities of 3 years or less. Central banks will raise or lower short-term interest rates to maintain economic stability.
Final thoughts: How the federal fund rates affects you
When federal interest rates are higher, it’s easy to think of it as an encouraging move that might increase your savings; however, it can discourage borrowing, as the cost becomes more expensive. With the recent Fed rate hike, consider it a great opportunity to start building an emergency fund, which can be helpful during economic changes.
You can stay ahead of any Fed rate moves by keeping an eye on your bank’s annual percentage yield (APY). Regularly looking at your bank statement and shopping around can also help you determine whether you’re getting a rate that’s competitive with other options that are out there. Boosting your credit score, paying off high-interest debts, or refinancing loans at a lower rate can also create more room in your budget to account for higher rates during this time.