The federal funds rate is one of the most widely used benchmark interest rates in the U.S. However, its effect on lending products you use, such as credit cards, auto loans, and mortgages, as well as its effect on the interest paid by your savings account, aren't well understood by many people.
With that in mind, here's a primer on the federal funds rate and how increases or decreases in it could affect your wallet.
What does it really mean when the Fed raises rates?
The easy explanation of the federal funds rate is that it is the interest rate banks charge other banks to loan money. My former colleague John Maxfield published an excellent piece on the details behind the federal funds rate if you're interested, but for our purposes, the federal funds rate is the interest rate that goes up when you hear that the Federal Reserve "raised rates."
The federal funds rate is widely used as a benchmark interest rate, and changes in it could therefore affect the cost of borrowing for all consumers. However, it's important to realize that while some types of interest rates move in tandem with the federal funds rate, not all do. Here's a quick rundown of how the federal funds rate can affect interest rates for you.
Rates that are directly affected
First and most importantly, the federal funds rate affects other benchmark interest rates, such as the "prime rate."
The prime rate is the interest rate at which banks will lend money to their most qualified customers. While the prime rate can vary slightly from bank to bank, it moves up and down with the federal funds rate. As a current example, The Wall Street Journal consensus prime rate is currently 4.75%, up from 4.00% a year ago. The Federal Reserve has increased the federal funds rate three times over the past year, by 25 basis points (0.25%) at a time, exactly the magnitude of the shift in the prime rate.
Furthermore, there are several types of consumer interest rates that are based on the prime rate. Two of the most common are credit cards and home equity lines of credit, or HELOCs. The interest rates on both of these types of loans are generally determined by adding a certain percentage to the current prime rate, which, as we've just seen, moves with the federal funds rate.
For example, one of my credit card agreements lists the interest rate as "Prime Rate [plus] 12.49%." In other words, when the prime rate was 4%, my credit card interest rate was 16.49%. Now that the prime rate has increased to 4.75%, my card's interest rate has risen by the same amount to 17.24%.
Rates that aren't linked to the federal funds rate
On the other hand, there are some interest rates that aren't directly linked to the federal funds rate but that tend to move in the same direction. The interest rate your bank pays on savings accounts and CDs, for example, doesn't rise in exact proportion to the federal funds rate. For example, the average interest rate on a 60-month CD is currently 1.03%, which has risen by just 22 basis points from 0.81% a year ago, despite a 75-basis-point increase in the federal funds rates.
On the borrowing side of things, the general rule of thumb is that the longer time period money is being lent for, the less correlation a particular interest rate will have with the federal funds rate. For example, you can expect the interest rate offered on a 36-month personal loan to move along with the federal funds rate more than say, a 30-year mortgage rate.
Having said that, even the longest-term borrowing rates clearly tend to move in the direction of the federal funds rate over time, as you can see in the chart of the 30-year mortgage rate below. Just be aware that it's not a perfect relationship.
How much higher could the federal funds rate get?
While the current federal funds target range of 1.50% to 1.75% may seem high in comparison with the past few years, it's still extraordinarily low from a historical standpoint. From 1970 through 2000, it was somewhat rare for the federal funds rate to be below 5%. And in the early 1980s, the federal funds rate reached as high as 20%.
To be clear, I don't think we'll see a double-digit federal funds rate again anytime soon. However, the point is that the rate can get significantly higher than it is now. Current Federal Reserve projections call for another seven or eight quarter-point rate hikes by the end of 2020, which would put the federal funds rate in the 3.25% to 3.75% area. The forecast also calls for rates to stabilize, or even fall, after that time, but as history shows, this isn't necessarily the ceiling, and it will depend on how the economy is doing at the time.