The Federal Funds Rate: What Is It, And How Does It Affect Mortgage Rates?
Scott Steinberg8-minute read
August 19, 2021
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 banks and various other lending institutions on unsecured loans that are borrowed overnight.
For simplicity’s sake, think of the federal funds rate as the interest rate at which banks lend money to one another. 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.
What Is The Federal Funds Rate?
Set by the Federal Reserve (the Fed), America’s central banking system since 1913, the federal funds rate is designed to help keep the United States’ economy operating smoothly. It’s a fiscal tool used to control the supply of available funds 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 (aka the fed funds rate, federal interest rate, or federal reserve rate) essentially provides a helpful means through which the Fed 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 the economy instead.
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.
Federal Funds Rate Vs. Federal Discount Rate
What’s the difference between the federal funds rate and the federal discount 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 sake of 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. 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. 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.
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How Is The Federal Funds Rate Determined?
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 Federal Reserve’s Federal Open Market Committee (FOMC) and Board of Governors are responsible for setting fiscal 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. 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 desires 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.
How Does The Federal Funds Rate Affect Mortgage Rates?
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.
Mind you: 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).
How Else Are Consumers Affected By The Federal Funds Rate?
As alluded to earlier, the federal funds rate is nonetheless highly influential when it comes to determining factors like the interest rates on credit cards, auto loans, student loans and other personal lending products. Changes made to the fed funds rate can have a significant impact on everyday consumers.
Variable interest rate credit cards are among the most popular options available on the market, and because of their potentially higher returns, a favorite option of credit card issuers.
These cards effectively allow consumers to enjoy short-term borrowing power. To avoid interest charges, balances must be paid in full every month. However, many credit card customers hold an active balance – a balance which can incur interest rate charges that are heavily influenced by the federal funds rate.
Put simply: When the Federal Reserve raises the fed fund rates, interest rates on credit cards go up as well. That’s because credit cards are keyed to a prime rate (the lowest rate at which any given consumer can borrow money), plus a certain percentage of fees that are determined by the credit card issuer. As this prime rate shifts in turn with the federal funds rate, the more that the fed funds rate goes up, the more that the prime rate tends to change as well.
Of course, small changes in interest rate may only result in a few dollars in extra charges. But larger changes in interest rates may make a larger dent in your wallet. The only way to avoid these charges, which can (and often do) change over time is to make a regular habit of fully paying off any outstanding credit card charges and not keeping a running card balance.
Car and auto loans typically tend to last 2 – 5 years and represent another form of short-term borrowing that can be influenced by the federal funds rate.
Mind you, automobile loans are more overtly influenced by your personal credit history and movements within the larger bond market. However, there’s still a correlation to fed funds rate, in that as the overall cost to borrow money in the market rises, auto loan interest rates tend to rise as well.
On the bright side, when the Fed raises its target rate, car loans don’t tend to mirror the full extent of these changes. Interest rates charged on car loans will increase as well – however, the actual interest rate that is levied on these automobile loan products generally tends to rise by a smaller amount.
Note that car loans operate on fixed-interest rate plans. Because rates are not variable, they won’t tend to shift as much as with adjustable-rate loan products.
Personal loans represent another form of short-term lending that generally comes with a 2 – 5-year term attached to any sums lent.
Regardless, as fixed-rate loan products, they’re unlikely to be as impacted by short-term interest rate pressures. More than anything else, your credit history and the term of your loan will be used to determine the interest rate that you’ll be given.
Data remains unclear as to the long-term effects of increases in the federal funds target rate on personal loans. Historically, interest rates on these loan products have risen when a fed funds rate increase occurs at times. But at other times, interest rates on personal loans have also risen when no adjustment to target rates was made by the Fed.
Student loans may be more impacted by changes to the federal funds rate, with the degree and extent of any such impact depending on what type of loan that you currently have.
For example: Federal student loans are fixed-rate products and don’t quickly react to movements in the market.
Loans provided by private lenders can be fixed or variable, though – and variable loan products tend to see interest rates rise when short-term rates go up across the board. The amount of any such changes will be determined by which index that your student loans are keyed to.
Applying for a fixed-rate loan product can serve as a hedge against volatility or uncertainty here.
Current Federal Funds Rate
The current federal funds rate (which serves as a benchmark for many common interest rate charges) is currently set to 0% – 0.25%.
This target rate was first set around March 15, 2020 with an eye toward stimulating and boosting an economy which has suffered from the effects of COVID-19.
It remains unchanged following recent meetings by the Fed in July 2021.
The Bottom Line
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.
Controlled by the Fed, the federal funds rate is a fiscal tool that America’s central bank uses to keep the United States’ economy in balance and steadily humming along. It can be used to simulate the economy or combat the effects of inflation.
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. Other financial products such as mortgages, credit cards, auto loans, student loans, and certificates of deposit may be affected by these shifts.
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 – one which 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 coming months, be sure to check out the mortgage interest rates forecast for 2021.
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