5 Facts You Should Know About the Federal Funds Rate
The fed funds rate may be of interest to economists, but what about the average person? Here are five reasons why it should matter to you.
Content originally published on Dec 12, 2019 and refreshed on Feb 4, 2021.
Every month or so you will see in the news an announcement like: “Federal Reserve leaves interest rates and asset purchases unchanged” or “The Fed won’t keep interest rates near zero forever — here’s what to do now”
You’ve heard it so many times, it is easy to tune out. It’s just one of the economic things that seems to be newsworthy, like a big drop in the stock market or a shift in the unemployment rate.
This may be of interest to economists, but for the average person? Not so much. Why should you care whether the fed funds rate goes up, goes down or stays the same?
It’s true that there’s at least one federal funds rate fact that doesn’t really matter to the average consumer: The fed funds rate is the interest rate that banks charge one another when lending Federal Reserve funds to each other on an overnight basis.
You are not a bank, so you don’t ever borrow or lend Federal Reserve funds. You don’t even know if the bank that holds your deposits is borrowing or lending fed funds. It’s mostly an accounting thing to make the books balance to meet regulatory requirements.
This doesn’t matter to you or your money. However, when the fed funds rate changes, it impacts other rates — and that does impact you.
Here are five fed funds facts that you should know.
Fed Funds Rate Fact #1: The fed funds rate is tied to the prime rate
Banks tie the prime rate (the rate they charge to their best customers) to the fed funds rate. They do this because the Federal Reserve Board raises the fed funds rate when it is concerned about inflation. Banks will raise the prime rate to help protect themselves from this inflation.
Most variable-rate loans are tied to the prime rate. When the Fed lowers its fed funds rate, banks lower their prime rate. This is because the Fed is concerned that the economy is slowing. Lower rates mean cheaper money, an incentive to borrow that injects money into the economy. This boosts the economy and can reverse the slowing.
Fed Funds Rate Fact #2: The fed funds rate can impact adjustable-rate mortgages
Adjustable-rate mortgages can be appealing if their lower rate makes for a more affordable loan payment. However, an affordable loan payment could be fleeting.
Banks can offer lower interest rates on these ARM loans because they are passing on the interest rate risk to the borrower. If the fed funds rate goes up, the ARM loan interest rate can also go up as defined in the loan terms. In an environment where fed funds are going up consistently over a long period of time, it can have a sizable impact on an ARM loan monthly payment amount.
Think twice about signing up for a favorable rate ARM loan. Look at what your payment would be if rates spike. Can you afford the increased monthly payment? If not, you could lose your property.
Fed Funds Rate Fact #3: Fixed-rate mortgages are independent of the fed funds rate
Fed funds influence short-term rates, so an announced change should have little impact on long-term mortgage rates. A 15-year or 30-year mortgage is tied more closely to the 10-year treasury bond rate. That rate is set by what the market will demand at auction or the secondary market.
Fed Funds Rate Fact #4: Inflation
Inflation does impact consumers. If the fed funds rates goes up, that is a signal that inflation may be in play. The bump in the fed funds rate may be enough to keep inflation in check, but then again, maybe not. If you see multiple fed funds rate increases, it is a signal that inflation may be increasing.
Fed Funds Rate Fact #5: Deposit rates
Savers love it when the fed funds rate goes up. They hate it when the fed funds rate goes down. This is because fed funds rate changes have a major impact on short-term savings rates. Remember in the 2000’s when it was possible to find money market rates as high as 5% — or maybe even higher? That was because the fed funds rate was much higher back then. Then fed funds dropped to 0% and deposit rates also reached super low levels.
That next fed funds rate news story may not be as interesting as the latest entertainment news, but now you know how it could impact you and your finances, so it is worth paying attention to the ups and downs of the fed funds rate.