What Is The Federal Funds Rate And How Does It Affect Mortgage Rates?

The federal funds rate (colloquially referred to as the fed funds rate) may directly or indirectly impact the interest rate that you’re charged on your home mortgage or personal loan. If you were to define it, it’s the interest rate that is charged to commercial banks and various other depository institutions on unsecured loans that are borrowed overnight.

Understanding how it works can help provide you with a better sense of how the economics behind the interest rates that you pay operate – and when they may be prone to rise or decline.

When you hear the term “federal funds rate,” it refers to the target interest rate set by the Federal Open Market Committee (FOMC), which is a part of America’s central banking system, the Federal Reserve. The federal funds rate is the suggested interest at which banks lend money to each other and was designed to help keep the U.S. economy operating smoothly.

In other words, it’s a fiscal tool used to control the money supply in the system and help keep inflation in check when commerce begins to overheat or stimulate the economy when it slows down.

The federal funds rate (also known as the fed funds rate, federal interest rate or federal reserve rate) essentially provides a helpful means through which the Federal Reserve can influence interest rates and borrowing. In practice, raising the federal funds rate makes it more expensive for individuals or organizations to borrow funds. Lowering it makes it easier for them to engage in borrowing.

In effect, if the federal funds rate is raised, money becomes less available, and short-term interest rates go up, which helps combat inflation. If it’s decreased, money becomes more readily available, and short-term interest rates sink, which helps stimulate economic activity.

Of course, the Fed can’t simply flip a switch and immediately transform the shape of the entire market or engage in discussions with every lending provider when it wishes to change financial policy. Rather, it influences lending practices by exercising control over a target benchmark rate – the federal funds rate – whose changes then trickle down to the rest of the economy.

When you hear that the Fed has raised or cut interest rates, this is what is being referred to: An adjustment to the federal funds rate.

Changes to it can in turn impact mortgage and loan interest rates, or interest rates on credit cards, savings accounts and certificates of deposit (CD). In other words, various loan and investment vehicles can be both directly and indirectly influenced by changes to the fed funds rate.

The federal funds rate describes the interest rate that banks charge other banks for lending them cash (typically excess monies on hand in their reserve balances) on an overnight basis.

For reference, by law, banks must keep a reserve in hand equal to a certain percentage of their total deposits (a reserve requirement) at the Federal Reserve bank. This standard ensures that financial institutions have enough cash at the start of every business day. However, banks do not earn interest on these sums. As a result, these financial institutions often try to stay as close as possible to the reserve limit without inadvertently dipping beneath it, prompting them to lend money between each other to stay compliant.

But as part of its purview, the Federal Reserve also sets a discount rate.

Discount rate refers to the interest rate that the Federal Reserve charges banks on monies that they elect to borrow from the Fed directly – also called borrowing at the “discount window.” As a general rule, this discount rate tends to hover higher than the fed funds rate, in part to help steer banks toward borrowing from other lending institutions and encourage more overall activity in the system.

The goal of the Federal Reserve is to promote a healthy economy. Rate changes encourage this by helping offset inflation and promote borrowing when stimulus is needed.

The FOMC and Board of Governors of the Federal Reserve System are responsible for setting monetary policy. The FOMC in particular is charged with managing open market operations in the federal reserve system and meets eight times each year to set the federal funds rate. Decisions the FOMC makes regarding the target interest rate influence the rate at which banks will be able to borrow monies and lend any excess reserves to each other on an overnight basis.

Any rate changes that the Federal Reserve elects to enact may occur based on several factors, including economic forecasts, indicators of inflation or as a response to a major happening that impacts the economy (e.g., a financial crisis). When it desires to stimulate the economy, it will lower the short-term funds borrowing rate, which typically prompts banks to lower the interest rates that they charge on loans to consumers for homes, cars and other purchases. When it wants to counter the effects of inflation, the Fed will raise the benchmark rate with an eye toward keeping inflation from spiraling.

In short, the FOMC sets the federal funds rate, and uses it as a tool to keep its finger on the scale of inflation and ensure that the economy is well-balanced.

A correlation exists between mortgage rates and the federal funds rate.

Note that most modern loans are traded on the bond market as mortgage-backed securities (MBS). While mortgage rates are most impacted by global trading movement (generally lowering when the stock market takes a downturn and bond markets benefit, and increasing when stocks are soaring), the Federal Reserve is the largest purchaser of MBS solutions.

The Fed does not directly seek to impact mortgages (10-year Treasury yields are more influential). But as a borrower, you may find that the Fed’s benchmarks are influenced by similar macroeconomic patterns. Where the Fed holds the most potential to move the needle here (and has the most direct influence on your monthly budget) is in its ability to influence the interest rates on adjustable-rate mortgages (ARMs) and home equity lines of credit (HELOCs).

The current federal funds rate (which serves as a benchmark for many common interest rate charges) was set to 0% – 0.25% on March 15, 2020 with an eye toward stimulating and boosting an economy which was already suffering from the effects of the COVID-19 pandemic.

On May 5, 2022, The Federal Reserve lifted the target range to 0.75% – 1.00%. This is the largest fed rate hike since 2000 that the Fed has made in an effort to reduce inflation levels.

The federal funds rate, or fed funds rate, is set by the Federal Open Market Committee (FOMC) of the Federal Reserve. It can be defined as the interest rate charged to various lending institutions such as banks on unsecured loans that are borrowed overnight.

Changes to the fed funds rate tend to trickle down to the rest of the financial system and may cause interest rates to rise or dip – especially on variable-rate loan products. So, the next time you hear in the headlines that the Fed has cut or raised interest rates, you’ll know what it means: A change in the federal funds rate may have direct or indirect influences over the various interest rates that consumers are charged.

To learn more about how changes to economic policy may impact your finances in the coming months, be sure to check out the mortgage rates forecast for 2022.