What Is the Federal Funds Rate, and How Does It Affect You?

Three of the driest words in the English language are "federal funds rate." And yet, understanding the federal funds rate is foundational to understanding how and why interest rates change -- and thus how this rate influences your everyday financial life.

What is the federal funds rate?

The federal funds rate is the interest rate that banks charge when lending money to each other from their reserve balances.

But why would a bank need to borrow money from another bank?

The federal government requires that all "depository institutions," such as banks and credit unions, keep a specific amount in funds (reserves) on hand each night so there's no risk that they'll run low. Those that don't have enough reserves borrow from other financial institutions that have more than enough on hand. The interest rate they pay to borrow the money is known as the federal funds rate.

How is the federal funds rate determined?

The interest rate that banks, credit unions, and savings institutions charge one another is determined at the Federal Reserve, the central banking system of the U.S.

Within the Federal Reserve is a 12-member committee called the Federal Open Market Committee (FOMC). The FOMC holds eight regularly scheduled meetings each year to determine what the federal funds rate should be.

Their decision is based primarily on the prevailing economic conditions. In other words, how well is the economy doing? Here's how it works:

• If it's headed toward recession, they're likely to lower the federal funds rate to try to spur businesses and individuals to borrow (and spend) more money.
• If the economy is red-hot, the FOMC is likely to raise the federal funds rate to slow growth (and the inflation that often accompanies an uncontrolled economic boom).

How the federal funds rate impacts interest rates

This is a bit complex, so here's an example. As of this writing, the federal funds rate is 0.25%. Let's say your bank did not have enough money in reserves last night and borrowed funds from another bank at 0.25%. You walk in today, hoping to take out a mortgage. Your bank won't lend you money at 0.25%, because that's the rate they're paying. Instead, they'll come up with an interest rate that will be competitive with other lenders' while still making them a nice profit.

Banks and credit unions set their own interest rates. While they all pay the same amount to borrow money, they can charge their customers anything they want (up to legal limits). But because they have to compete with other banks, they generally don't charge astronomically high rates. They want to keep you as a customer, so they charge somewhere in a middle -- enough to make a profit, but not so much that you'll be scared off.

Is it possible to predict where interest rates are headed before I borrow?

If you have a few minutes to kill, try searching the following question: "What's going to happen next with interest rates?" When it comes to the rates we pay on things like credit cards and consumer loans, the answers are all over the map. Some predict that rates will be flat for months to come, while others are just as sure that rates are about to shoot sky-high (and the people telling you rates are about to go up are often the ones trying to get you to buy something on credit -- right away).

We can speculate on what consumer interest rates will do next, but it all comes down to what's happening with the federal funds rate. Remember how the FOMC raises or lowers the federal funds rate depending on economic conditions? If the economy needs a little prod to get moving, the FOMC lowers the rates to encourage borrowing and spending. If the economy is like a runaway train, they slow things down by raising interest rates.

If you're really curious about what's about to happen with consumer interest rates, keep your eye on news from the Federal Reserve. The next time you read that the Fed has raised the federal funds rate, it's a safe bet that some consumer rates will tick up as well.

What about existing loans and financial products?

If you have a fixed-rate mortgage, auto loan, personal loan, or any other consumer loan with a fixed rate, it doesn't matter what happens with the federal funds rate. Your interest rate will, by design, stay the same for the entire term of the loan. The same is true of some deposit accounts, like CDs. Some CDs have a fixed rate, and some have a variable rate. Before signing on the dotted line for any loan or financial product, make sure you understand whether the rate is fixed or variable.

If you have a variable-rate loan or product -- for example, an adjustable-rate mortgage or a credit card -- your interest rate will likely rise or fall based on the federal funds rate.

As unexciting as the term "federal funds rate" may be, it plays an indirect role in most of our big financial decisions. For that reason alone, it's worth understanding how it works.

Still have questions?

Here are some other questions we've answered:

• What is FDIC insurance?
• Credit union vs. bank: What’s the difference?
• Where to put your money during a recession