Many people take out loans to pay for things like a home or a car, or they might open a credit card. While each of these financial products may be different, they share one thing in common: interest rates.
If you want to borrow money through a mortgage, personal loan or credit line, remember that you'll need to pay back the amount plus interest.
But how much interest will you pay? That is determined by the rate you're quoted — which itself is determined in part by the federal funds rate maintained by the Federal Reserve.
Sounds complicated? The relationship between the federal funds rate and your interest rate may be simpler than imagined.
You may have heard or read about the Fed lowering and raising rates in the news. To clarify, that's when the Fed decides to decrease or increase the federal funds rate, its benchmark borrowing rate.
Banks and other financial institutions are required to have a reserve account with the Fed to cover customer deposits and other obligations. At the end of each business day, those reserves have to meet a minimum level — but some banks may have excess reserves, while others don't have enough.
That's where the federal funds rate comes into play. This is the interest rate that banks charge one another when lending or borrowing reserves on an overnight basis.
The target rate is decided by the Federal Open Market Committee (FOMC), which meets eight times a year to increase or decrease rates, or hold them steady. The FOMC, a 12-member group, uses the rate as a monetary policy tool as well, primarily to keep inflation down and to encourage employment and economic activity.
The federal funds rate can have a big impact on your personal finances.
While you won't be charged the federal funds rate when borrowing through a mortgage, the interest rate you are quoted may be influenced by it.
According to the Fed, "changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services."
If the federal funds rate increases, it may raise other interest rate markets; conversely, if it falls, interest rates for loans or lines of credit may similarly trend downward, which often stimulates economic activity and growth.
However, a low federal funds rate often means interest rates are low for savings accounts or Certificates of Deposit (CDs).
Homeowners with a variable-rate mortgage should pay close attention to changes in the federal funds rates. Such loans feature an interest rate that floats with the broader market and is readjusted periodically. If rates are climbing higher when your mortgage rate rebalances, you could see high costs. Alternatively, if rates are falling, you could benefit from cost savings.
Getting the best interest rate is important for your financial plan. You can learn more about which mortgage is best for you by starting the application process with The Federal Savings Bank.