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

10 Min Read
Updated March 6, 2024
Written By
Kevin Graham
Row of gray houses.

If you’re a regular follower of interest rates, you probably know that they’re going up. Perhaps you’ve even heard it’s because the Federal Reserve has raised the federal funds rate. But why is this the case and what are the practical effects of these policy changes? Most importantly for home buyers and those looking to refinance, how does it affect mortgage rates?

What Is The Federal Funds Rate?

The federal funds rate is the target range of interest rates the Federal Open Market Committee (FOMC) would like to see banks use when they borrow money from each other overnight to make sure they have enough liquidity on hand. It’s always expressed in a range of 25 basis points or 0.25%. For example, the current target range for the federal funds rate is 3.75% – 4%.

However, the Federal Reserve doesn’t actually set this rate. The rates are negotiated between individual lenders when they borrow from each other. The Federal Reserve can only influence this rate, which it does by altering its patterns of debt purchasing.

When the Fed is purchasing more debt, the rate of interest can be lower and you still know you’re going to attract a buyer. When the Federal Reserve is selling debt, the rate negotiated between banks is going to be higher because the Federal Reserve isn’t buying it. Because there’s one less major source of liquidity, other lenders can charge higher interest rates.

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What Is The Federal Interest Rate?

There is no interest rate that’s set at the federal level. There are two rates the Federal Reserve either sets or has influence over. We discussed the federal funds rate and how that’s the interest rate banks charge each other. There’s a second rate called the discount rate.

If banks are unable to get the funds they need to match federal requirements for reserve cash on hand, the Federal Reserve is the lender of last resort. It lends at the federal discount rate. We’ll get into it in a minute, but you’re not actually getting a discount in the way consumers think of the word.

For now, the important thing to note is that both the federal funds rate and the discount rate impact effective interest rates across the rest of the economy.

How Are Interest Rates Determined?

The Federal Reserve only determines one interest rate, and it’s because it’s doing the lending. They set the discount rate at which banks can borrow from them. This is purposely set slightly higher than the rate a bank could get on the open market if they were to trade between banks in order to discourage borrowing from the Fed itself.

The discount rate has an influence on what banks do, but it’s important to note that the major way the Federal Reserve tries to impose its will on the market is through trading on the open market.

If the Federal Reserve is buying lots of government bonds, rates end up lower because there’s more cash available to lend. If it’s selling instead of buying, rates go up because a source of funding is gone.

What Is The Federal Reserve?

The Federal Reserve (the Fed) is the central bank of the United States. Its main mission is threefold.

The U.S. Central Bank

The Fed is the central bank of the United States. This means it has broad discretion to control monetary supply. Its actions to control supply are referred to as monetary policy. Its primary way of handling this is by influencing market interest rates. It does this by setting the target range for the federal funds rate and to a lesser extent, by setting the discount rate.

The FOMC is the open market operator of the Federal Reserve and is in charge of putting these policies into action through trades on the market with other lenders. While it’s not the only participant, it has the ability to have outsized influence in the market because of the volume of trading it does. For example, the most recent Federal Reserve balance sheet (as of this writing) showed it held more than $5.5 trillion worth of U.S. Treasury securities alone.

The Fed’s Mission

It’s easy enough to talk about the Fed having control of the money supply, but it helps to understand the why behind the what. At its creation by Congress, the Federal Reserve was given a three-pronged mission. It’s supposed to implement policy consistent with stable prices, moderate interest rates and maximum employment. The challenge is balancing it all.

For example, lowering interest rates tends to lead to higher levels of employment as it’s easier for both businesses and consumers to spend. On the other hand, that can lead to higher levels of inflation because if people have more money, they’re going to spend more, which can lead to higher prices.

The way to cut down on that involves raising interest rates, but that makes borrowing and spending more expensive for both businesses and consumers, which can lead to higher levels of unemployment.

Fed Funds Rate Vs. Discount Rate: What’s The Difference?

The difference between the federal funds rate and the discount rate is subtle, but important. The discount rate is the interest rate charged by the Federal Reserve to act as an emergency backstop lender for banks that are having trouble finding funds to meet minimum reserve requirements elsewhere.

By contrast, the federal funds rate is set by the market participants themselves in each individual transaction banks make with each other to borrow and lend funds. What’s actually tracked is something called the effective federal funds rate, which is a weighted average of the interest rate on all such transactions between banks. But the Federal Reserve has no control over it.

Why Does The Fed Change Interest Rates?

The Federal Reserve’s policy changes are based on macroeconomic conditions at any given moment. The Fed talks about the things it tracks in its statement at the end of every meeting.

Among the key things tracked are employment, actual inflation and expectations. Inflation expectations are as important as what’s actually happening because if consumers expect prices to keep rising, they’ll buy now, which can cause prices to rise because it keeps demand at an extremely high level.

Beyond data points, they also look at the news cycle and how that’s impacting the markets. For example, the war in Ukraine has led to sanctions on Russian oil, which leads to higher gas prices because of decreased supply. We live in a truly global economy.

In A Recessionary Economy

When the Federal Reserve senses the economy slowing down, it tends to act to prevent or lessen the pain associated with a recession. The most recent example of this was the actions it took at the beginning of the COVID-19 pandemic. In an effort to stimulate the economy and encourage buying, it’s slashed the federal funds target rate to near 0%.

The other action that was taken involved buying tons of mortgage-backed securities (MBS) and Treasury bonds. This was done because housing makes up an incredible proportion of employment and spending in this country. It keeps people employed in construction, retail and finance.

In An Overheated Economy

Now we are in the opposite situation where there are signs that the economy may have expanded too quickly. In addition to the actions of the Fed, one of the other things the government did with an eye toward giving people relief during the pandemic was three rounds of stimulus checks for qualifying Americans. It helped, but combined with the war in Ukraine pushing up oil prices and some continuing supply chain issues, prices have risen at an incredible clip.

In an effort to bring inflation under control, the Federal Reserve has begun to raise the target on the federal funds rate. In addition, it’s selling the Treasury and mortgage bonds it purchased at the beginning of the pandemic, causing interest rates to rise further. This has the effect of making people hold onto their money rather than spend it, which in theory should cool inflation.

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How Are Consumer Loan Interest Rates Affected By The Federal Funds Rate?

The rates consumers pay are always going to be higher than the discount rate and federal funds rate because the bank has to be able to charge more than it costs for it to actually get the money in order to sustain itself.

The lowest rate a bank will offer its most well-capitalized corporate customers is called the prime rate. Rates to corporations are considered relatively less risky than consumer loans. Every other rate offered is based on the prime rate, which in turn is derived from the federal funds rate. Generally, the higher your credit score the better your terms will be.

Credit Cards

Credit cards can be a more risky form of lending because the debt is unsecured, meaning there’s nothing for the lender to take back if you don’t make a payment. For this reason, and the fact that the balance is constantly changing based on new payments and purchases, these have some of the highest interest rates you can get.

Because credit cards are revolving debt with balances that change every month, these are the most impacted by short-term interest rate changes like those of the discount window or the federal funds target rate. They go up or down almost instantly based on the changes. This is one of the primary differences between installment and revolving debt. With installment debt, the balance and interest rate don’t change very often.

Because of the higher rates, if you’re not in the habit of routinely paying off your balance, this could lead to unmanageable debt for borrowers. It’s important to set good habits from the start.

Personal Loans

A personal loan is an unsecured loan given strictly based on your credit profile. However, unlike a credit card, it comes with a fixed rate and is paid off over a set term. Rates for this type of loan are still higher than secured loans backed by some type of property, but it’s important to note that they’re lower than credit card rates. For this reason, a personal loan for debt consolidation can be helpful. You can pay off credit card debt with a single loan repayment rather than multiple balances over many cards.

Mortgage And Auto Loans

Auto and mortgage loans are certainly still impacted by changes in the target for the federal funds rate, but it’s less of a one-to-one correlation because the rates are longer-term and further removed from the day-to-day funding needs of banks.

These also tend to be lower rates than you could get with a personal loan or credit card because of the key differences between secured and unsecured loans. Because secured loans are backed up by property, they’re less risky and come with lower rates.

The downside is if you don’t make the payments, a lender can take your car back or initiate foreclosure on your house. If you think you’re going to have trouble making your payments, it’s important to contact your servicer right away.

The Bottom Line: The Fed Funds Rate Is An Important Economic Target

The Federal Reserve has a great deal of influence over interest rates due to the various actions it takes in the market in support of public pronouncements around targets for the federal funds rate. However, it doesn’t actually set rates beyond the Fed discount rate that lenders are charged to borrow directly from the Federal Reserve.

If you’re looking to buy a home or refinance your current mortgage, it’s important to pay attention to the direction of interest rates because it impacts your budget and the type of loan that will help you accomplish your financial goals.

If you’re ready to move forward, you can to lock in your rate and protect yourself from potential future upward movements.

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