Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
When you hear that the Federal Reserve is going to raise or cut interest rates to slow inflation or stimulate the economy, it’s the federal funds rate they are talking about. But what is the federal funds rate? Strictly defined, the federal funds rate is the interest rate that the Federal Reserve (a.k.a., “the Fed”) recommends that banks charge each other for unsecured overnight loans. However, this target rate doesn’t just impact banks. It also influences other interest rates, such as those you pay on credit cards, mortgages, and all types of small business loans, and even how much you earn on your savings. In fact, the federal funds rate has a profound impact on the overall U.S. economy. Read on to learn how this rate is determined, how it affects the cost of getting a business or consumer loan, and why you should keep an eye on it.
What Is the Federal Funds Rate?
The federal funds rate (also known as the federal funds target rate or the fed funds rate) refers to the target interest rate set by the Federal Open Market Committee (FOMC), which is the policy-making body of the Federal Reserve System. This is the rate at which the Fed suggests commercial banks borrow and lend their excess reserves to each other overnight.The federal funds rate is easily confused with, but is not the same as, the federal reserve discount rate, which is the rate the Fed itself charges banks for loans.
Why do banks have to borrow money?
Banks are required by law to keep a certain percentage of their customers’ money on hand with the Fed. They earn no interest on this money. As a result, banks like to stay as close to the reserve limit as they can without going below it, lending money back and forth overnight to maintain the required level.
How Does the Federal Funds Rate Work?
The Fed is tasked with keeping the U.S. economy healthy. One way it does this is by setting the federal funds rate. The FOMC meets eight times a year to discuss and establish the federal funds rate. The committee bases the rate on a variety of economic variables that could indicate the U.S economy is poised for recession, inflation, or stability. Whether they raise, lower, or maintain the rate depends on the FOMC’s outlook on the economy. When the FOMC wants to stimulate the economy, it will lower the federal funds rate. This makes it cheaper for banks to borrow money from other banks overnight and allows them to lower the rate they charge consumers and businesses for loans. If the Fed wants to counter the effects of inflation, it will raise the benchmark rate. This makes borrowing more expensive for banks – and, in turn, everyone else – and can help cool down the economy.
What Does the Federal Funds Rate Impact?
The federal funds rate is pivotal to the U.S. economy. When the FOMC meets, they are essentially determining whether the economy is stable, experiencing inflation, or going through (or heading into) a recession. Because the decision to raise rates limits the amount of cash in circulation, and lowering it increases the amount of money in circulation, the federal funds rate impacts the whole economy, including growth, employment, and inflation.Investors also closely watch the federal funds rate. If the rate goes down (or is expected to), it can prompt a jump in the stock market, since borrowing costs for companies may soon be lower. A decline (or expected decline) in the federal funds rate can have the opposite effect on the market.
How Is the Federal Funds Rate Determined?
The FOMC looks at the following factors to determine whether or not to raise or lower rates:
Core inflation rate
Durable goods orders report
Consumer spending
Pricing trends (including housing)
Wages and income
Employment/unemployment
Foreign exchange markets
Business investments
Supply and demand
When viewed holistically, all of the above data provides a snapshot of the U.S. economy, and suggests whether the market is stable, or whether inflation or a recession is on the horizon.
Federal Funds Rate vs Regular Interest Rates
Federal Funds Rate
Regular Interest Rates
Intended for interbank loans
✓
X
Used as a means to combat inflation or recession
✓
X
Borrower’s credit history and credit score determines rate
X
✓
Set by the FOMC
✓
X
Determines/influences the cost of taking out a business or consumer loan
✓
✓
Influences prime rate
✓
X
Primarily used for overnight-loans
✓
X
How the Federal Funds Rate and Prime Rate Interact
The federal funds rate is the basis for the prime rate, which is the interest rate banks charge their most creditworthy customers, such as large corporations. The prime rate can be different for each bank, but it generally runs about 3% higher than the federal funds rate. Thus, if the federal funds rate goes up, the prime rate will follow suit. If the federal funds rate falls, so will the prime rate. The prime rate, in turn, impacts the cost of other loans, including small business loan rates and consumer loan rates.
Federal Funds Rate and Consumer Lending
The federal funds rate indirectly affects virtually every financial product on the market, from credit cards to car loans to small business financing. Here’s how:
Mortgages
Mortgage rates usually move at the same time as the federal funds rate. However, because the housing market is one of the variables the FOMC looks at when establishing rates, it’s hard to say which one takes the lead. If anything, they each influence the other. If there are rumors of a federal funds rate hike, lenders may start changing their rates in anticipation of the change. This makes it look like they are in lockstep with one another. If you already have a home mortgage and it’s a fixed rate mortgage, you won’t see any changes when the federal funds rate changes. However, if you have an adjustable rate mortgage or a home equity lines of credit (HELOC), then you will likely see changes in what you pay if the federal funds rate changes.
Personal Loans
Personal loan rates are most influenced by a borrower’s credit history and the terms of the loan. However, a change in the federal funds rate can trickle down and impact the rate a consumer will be charged for a personal loan. In addition, those who have variable rate personal loans may see their rates increase after a rise in the federal funds rate, and vice versa.
Student Loans
Borrowers with variable interest student loans from private lenders will likely see changes in their rates whenever the federal funds rate changes. However, federal student loans have fixed rates, which means once you have the loan, your rate won’t change no matter what happens to the benchmark rate.
Auto Loan
Auto loan rates are highly influenced by the type of car and the borrower’s credit score and history. However, auto loan lenders also look to the Fed’s benchmark rate when setting car loan rates. When the Fed raises interest rates, auto loan rates may rise as well, and vice versa. The good news is that car loan rates will typically rise to a much smaller degree than the federal funds rate.
Credit Cards
Most credit cards today have variable interest rates, and these rates are usually closely tied to the prime rate. The prime rate, however, is based on the federal funds rate. When the federal funds rate changes, the prime rate changes. Any change to the prime rate will, in turn, impact how much interest you will pay on a credit card balance.
Small Business Loans
When you apply for a small business loan, the rate you will be quoted will be based on the prime rate. Since the prime rate fluctuates with the federal funds rate, any change in the benchmark will affect the interest rate a lender will offer your business. The exact rate you will be quoted will depend on your business’s qualifications and credit history.
The Takeaway
The federal funds rate is the rate that the Federal Reserve encourages banks to charge one another for overnight loans. These short-term loans allow banks to maintain their legally required cash reserves. The federal funds rate is regulated by the FOMC, which meets eight times a year to discuss and make any changes. Depending on the economic outlook, they may raise or lower rates.Even though the federal funds rate is only meant for interbank loans, it indirectly influences other loans, including credit cards, mortgages, and small business loans. If you already have a fixed interest loan, changes in the benchmark rate won’t affect your rate. However, if you have a variable rate loan, or you’re in the market for a new loan, it’s a good idea to keep an eye on the federal funds rate, since any shift can impact the cost of borrowing.If you’re interested in comparing rates for small business loans right now, Lantern by SoFi can help. With our easy online comparison tool, you can get offers from multiple small business lenders with just one application and no commitment.
Frequently Asked Questions
What does the federal funds rate do?
Why is the federal funds rate so influential?
How is the federal funds rate set?
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Photo credit: iStock/fstockfoto
SOLC0222015
About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
