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Federal Funds Rate: What It Is And How It Works

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Published on January 8, 2021
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When we get approved for credit or take out anything from personal loans to a mortgage, there’s an interest rate charged against the balance that we owe. If you’ve always regarded the process of setting these interest rates as if it were shrouded in some sort of mysticism, you could hardly be blamed. After all, we might take the occasional look at the stock market or peek at our 401(k), but how many of us really have time to dig into the mechanics of economics or follow the markets?

This post aims to give you a look at how these rates are actually set. Although there are a variety of factors, the federal funds rate is usually a good place to start your investigation.

Federal Funds Rate, Defined

The United States has a free market economy, but it has some controls to keep things from going off the rails. These controls are meant to prevent things like high unemployment levels and rampant inflation. Monitoring developments in areas that impact the economy is the responsibility of the Federal Reserve, America’s central banking system since 1913, also known as the Fed.

In order to keep inflation in check or to stimulate the economy, the Federal Reserve is able to control the money supply. It does this, at least in part, through the federal funds rate.

The federal funds rate – also known as the fed funds rate, federal interest rate and the federal reserve rate – is the interest rate charged to banks and other lending institutions on unsecured loans borrowed overnight.

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Federal Reserve Rate Changes

The overall goal is to promote a healthy economy and the rate change does this by helping control inflation, encouraging high employment rates and ensuring reasonable interest rates. The Fed may change rates based on several factors, including signs of inflation, economic forecasts or in response to a major event that affects the economy.

When Does the Fed Change Interest Rates?

When the Fed wants to stimulate the economy, it will lower the short-term funds borrowing rate. In response, banks typically lower the interest rates they charge to consumers for a variety of loans. This encourages borrowing and helps stimulate the economy because you’re able to more easily get financing for big purchases like homes and cars. Lower rates also encourage businesses to borrow money to expand and build, which stimulates the economy.

However, there’s a flipside to this. If it’s cheaper to borrow money, this means the money you do have in the bank is worth less in comparison to a time when you might be receiving a higher interest rate. This can also lead to inflation because if money is worth less, it’s going to take more of it in order to purchase the things we want and need.

A little bit of inflation can be a good thing because it encourages people to buy now before the price goes up. However, you want to keep inflation relatively low because you don’t want things getting out of control to the point where you’re spending $20 on a carton of eggs. For that reason, interest rates can’t stay artificially low forever.

The fed funds rate is the Fed’s way of keeping a finger on the inflation scale.

Federal Interest Rate History

Now that you know what the federal funds rate is, where does it stand? For many years after the 2008 financial crisis, the Federal Reserve kept the federal funds rate at or near 0%. This enabled banks to borrow money essentially for free, which drove lower interest rates for consumers. This in turn encouraged spending on the big-ticket items that can be a boon for the economy.

You don’t want to overstimulate the economy and allow too much inflation. With that in mind, the Federal Reserve began raising interest rates again in late 2015. Rates rose steadily until 2019, when the Fed cut rates three times in an attempt to keep the economy from slowing. In 2020, the Fed lowered rates drastically, near 0%, to help stimulate a struggling economy caused by COVID-19.

Here’s a look at the average annual rates over the last 20 years. You’ll be able to see how historic events, like September 11, the financial crisis of 2008 and the COVID-19 pandemic, have affected the rates.

How Does The Federal Funds Rate Affect Consumer Interest Rates?

Knowing what we know now, what’s the effect on the consumer when it comes to things like rates on credit cards, mortgages and other loans? Let’s dig in.

Credit Cards

While it’s possible to get a fixed-rate credit card, they’re not as popular among industry players as variable interest rate cards, because that’s where the money is for the card issuers. We’ll focus on the variable interest rate cards that most consumers have because they’re easier to find.

Credit cards involve the shortest of short-term borrowing. To avoid interest payments, a consumer has the option of paying off the entire balance every month. Because the money is lent over such a short-term, the federal funds rate heavily influences credit cards. How heavily?

If the Federal Reserve increases the federal funds rate, credit card rates go up in lockstep.

Credit card rates are tied to a prime rate, the lowest rate at which a consumer can borrow money, plus a certain percentage that’s up to the card issuer. Since the prime rate changes with the federal funds rate, this is the primary way the rate goes up.

How likely are you to notice the difference, though? The answer is not very likely as small changes will typically alter your payment by a few dollars.

Of course, because the interest rates on credit cards are so high, if you make the minimum payment, you’ll be paying forever and paying the greatest possible interest. If you can, the best thing to do is to pay off the balance each month.

If you have lots of credit card debt, you may find that debt consolidation is helpful.

Auto Loans

Car loans are the next ones we’ll go over because they’re also relatively short-term. A typical auto loan might be anywhere from 2 – 5 years.

However, auto loans are still traded within the free market, so they’re not directly tied to any particular rates. It’s more about movements within the bond market. They still go up because the overall cost to borrow any money rises, but not by as much as you think.

An analysis by USA Today shows that when the Federal Reserve raised interest rates in June 2017 by 0.25%, auto loan rates only increased by somewhere between 0.118% and 0.125% depending on the term of the loan.

Auto loan rates are much more influenced by your personal credit history.

Personal Loans

Let’s cover personal loans next because it’s another loan with a 2 – 5-year term, typically.

In order to get an idea of the effects of federal funds rates on personal loans, we looked at the behavior of personal loan rates in the short and long-term from the Federal Reserve rate using data from the St. Louis Fed. The data is based on a 24-month loan term.

So, do short-term rates have an effect on personal loan interest rates? Maybe, but maybe not.

In the months following a rate increase by the Fed, interest rates briefly popped up a bit, going from 9.66% in November 2015 to a 10.03% rate in February 2016.

However, there was a 0.81% increase in the average personal loan interest rate between August and November 2017. There was no increase in Federal Reserve interest rates at this time.

As with auto loans, personal loans are also fixed rates, so they’re not as likely to be responding to short-term interest rate pressures. Your credit and the term of your loan will determine your rate more than anything else.

Student Loans

How much your student loans will be affected by a rate hike may depend on the type of loan you have. Federal student loans are fixed and don’t react right away to movements in the markets. Rates are set periodically by Congress.

If you have student loans from private lenders, those can be either fixed or variable. If they’re variable and short-term rates go up, the interest rate on your loan will likely rise. How much depends on what index the student loans are tied to.

If you can get fixed-rate loans, that’s great. If not, you still may be able to help yourself by paying the interest early while still in college. It will keep the interest on private loans from building up during school years and during your grace period. You can also consolidate them later on if you have good credit to get a better rate.

Mortgages

There’s definitely a correlation between mortgage rates and the federal funds rate. For example, at the start of 2020, before COVID-19 hit, mortgage rates for the 30-year fixed were 3.72%. At the time of this writing, at the start of 2021 and still in the midst of the pandemic, rates are 2.67%, according to Freddie Mac’s current mortgage rates data. That’s a drop of 1.05%.

In addition to the fact that the loans are fixed, most loans nowadays are traded as mortgage-backed securities (MBS) on the bond market. While traders pay attention to what the Federal Reserve is doing, there are other factors at play.

Mortgage rates are most affected by global trading movements. While this is a bit simplified, in general, when the stock market has a downturn, the bond market tends to benefit in the form of higher bond prices. This leads to a lower yield and lower rates for things like mortgages. In these situations, the guaranteed yield on bonds makes them a safer asset.

On the other hand, when stocks are booming, people sell their bonds. This is done to free up money to buy stocks. To attract investors, bond yields must be higher, which leads to higher mortgage rates.

Another thing that’s keeping mortgages from higher rates right now is that the Federal Reserve is still in the process of buying a ton of mortgage bonds. This is similar to the strategy that was used after the 2008 crisis. At the time, the Federal Reserve stepped in to buy a bunch of MBS in order to keep mortgage rates artificially low and stimulate the economy.

Since the Federal Reserve has become the biggest purchaser of MBS, what happens if and when the Fed ever sells those back into the market? Another purchaser, or more likely group of purchasers, would have to bet big on MBS in order to keep rates as low as they’ve been before the Fed entered the market as part of its effort to promote cheaper consumer borrowing.

Knowing that rates are currently at all-time lows, if you’re interested in getting started with a mortgage, you can do so online with Rocket Mortgage®.

Apply Online with Rocket Mortgage

Get approved with Rocket Mortgage® – and do it all online. You can get a real, customizable mortgage solution based on your unique financial situation.

Apply Online

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