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The federal funds rate is a benchmark interest rate set by the Federal Open Market Committee (FOMC), a committee within the Federal Reserve. The rate is used by commercial banks when lending to each other on an overnight basis. When the federal funds rate changes, it indirectly influences the interest rates banks and other lenders charge on loans and credit cards, as well as the rates banks and credit unions offer on deposit accounts.
Understanding the mechanics of the federal funds rate can help you get an idea of how it affects the broader economy and your personal budget.
How Does the Federal Funds Rate Work?
The FOMC, which consists of 12 members chosen from the Federal Reserve System and Federal Reserve Bank presidents, meets eight times each year to evaluate the state of the U.S. economy and determine whether to intervene using monetary policy.
The FOMC engages in monetary policy in three ways, including:
- Buying and selling securities
- Establishing reserve requirements for member banks
- Adjusting the discount rate that Federal Reserve banks charge member banks for collateralized loans, usually on an overnight basis
Each of these tools affects the supply and demand of deposits that banks hold at Federal Reserve banks, which, in turn, affects the federal funds rate.
How the Federal Funds Rate Affects Banking and Other Financial Products
When the FOMC raises or lowers the federal funds rate, it directly impacts the costs banks earn and pay to lend and borrow between each other.
In turn, banks and other financial institutions will typically adjust the interest rates on their deposit and loan products.
For example, if the federal funds rate goes up, interest rates on credit cards, personal loans, student loans, auto loans and adjustable-rate mortgages follow suit. At the same time, you'll also see higher annual percentage yields (APYs) on savings accounts, money market accounts, certificates of deposit and interest-bearing checking accounts.
On the flip side, if the FOMC lowers the federal funds rate, interest rates on loans and credit cards, as well as on interest-bearing bank accounts, also go down.
Why the FOMC Changes the Federal Funds Rate
The FOMC's goal is to maintain stable prices for consumer goods and services and to support maximum sustainable employment. The primary way the Federal Reserve measures these two objectives is the inflation rate—the agency's target inflation rate is 2%. When the inflation rate exceeds that target, the FOMC may take several actions, including increasing its federal funds rate.
The idea is that when the cost of borrowing and the benefit of saving both go up, consumers will spend less and save more. As a result of this pullback in spending, demand for consumer goods and services decreases, helping to bring down prices or slow price growth—in theory, at least.
On the other hand, if the economy is in recession, the FOMC may reduce its federal funds rate, lowering the cost of borrowing and the benefit of saving. In turn, consumers may spend more, which helps to stimulate the economy.
In other words, adjusting the federal funds rate causes a ripple effect in the economy. In addition to interest rates that consumers earn and pay, it also affects foreign exchange rates, the amount of money and credit in the system, employment, the price of goods and services and more.
What Is the Current Fed Rate?
As of March 22, 2023, the current federal funds rate is a range of 4.75% to 5%, much higher than the 0% to 0.25% range set in March 2020 in response to the pandemic's effect on the economy.
The FOMC is expected to raise the rate several more times throughout 2023 to combat persistent high inflation rates.
Federal Funds Rate vs. Prime Rate
Both the federal funds rate and the prime rate affect how much you pay when borrowing money, but the two are not interchangeable.
While the federal funds rate is used by banks to lend to each other, the prime rate is used as a benchmark rate for banks and other lenders to determine the rates they charge consumers.
The prime rate, which is set by the largest lending and financial institutions, is usually 3% higher than the federal funds rate. So, with a federal funds rate range of 4.75% to 5%, the current prime rate for many financial institutions as of the time of publication is 8%.
That's not to say that the prime rate is the lowest interest rate you can get—actual interest rates can vary depending on the lender and the borrower. But the rate provides a benchmark lenders can use to guide their lending decisions.
How the Federal Funds Rate Affects You and What You Can Do
When the federal funds rate changes, it can directly affect your budget and your savings. Here are some ways the federal funds rate can impact you and what you can do about it:
- If you have variable- or adjustable-rate loans: Depending on the loan agreement, your rate may adjust monthly, quarterly, semi-annually or annually based on the current benchmark rate. As a result, your monthly payment may go up the next time your rate adjusts. If possible, consider refinancing your loan with a fixed-rate loan to lock in a rate.
- If you have fixed-rate loans: With a fixed interest rate, your interest rate and monthly payment will remain the same for the life of the loan. As a result, you don't have to worry about your payments fluctuating with the federal funds and prime rates. However, rates on new loans will be affected by the federal funds rate. When rates are high, consider putting off borrowing until they go back down.
- If you have credit cards: Most credit cards have variable interest rates, and there's no set schedule for increases or decreases, which means that your annual percentage rate (APR) may follow the federal funds rate more quickly than other types of variable-rate loans.
- If you have cash you can save: If the federal funds rate is high, it may be a good idea to take advantage of high-yield savings accounts, which offer APYs that are much higher than traditional savings accounts. This can help you bolster your emergency savings. If the federal funds rate goes down, you may consider other places to stash cash for mid- and long-term savings goals, but keep short-term savings in a bank account where it's safe and easily accessible.
Also, if the federal funds rate is high, now may be a good time to work on building and maintaining a good credit history. While there isn't much you can do about market interest rates, you can still qualify for the best rates available with a strong credit profile.