How Federal Interest Rates Work

If you’ve ever owned a credit card, borrowed money or put funds in a savings account, you know that interest rates have an impact on how much money stays in your pocket. There’s a complex system that dictates what interest rates are at any given time. Here’s how it works.

What Are Federal Interest Rates?

According to Peter C. Earle, an economist, writer and researcher at the American Institute for Economic Research, interest rates can be thought of as the price of borrowing, or fee received for lending money. “Quite simply, it’s the amount charged by a lender for use of an asset, expressed as a percentage of the principal value,” he says.

Interest rates for savings accounts and loans are what you see when you make decisions on financial products. But those rates are based on another rate: the federal funds rate.

The Federal Reserve, America’s central bank, requires all depository institutions — namely, banks — to keep a certain amount of cash on hand each night. If a bank’s cash reserve is under that minimum, they can borrow funds from another bank to meet the requirement. The interest rate banks charge each other to borrow money overnight is known as the federal funds rate. Earle explains that this rate is set by the Fed — specifically, by the Federal Open Market Committee, or FOMC.

[Read: The Best Low-Interest Credit Cards of 2018.]

Banks base their interest rates on the Fed’s rate. “This directly impacts (consumer) interest rates, such as home equity lines of credit, credit card interest rates and car loans,” Earle says. In fact, the federal funds rate impacts just about all other interest rates on deposit accounts and loans.

Why Do Federal Interest Rates Change?

According to Elysia Stobbe, a mortgage and real estate expert and author of “How to Get Approved For The Best Mortgage Without Sticking a Fork in Your Eye,” “The Federal Reserve changes their rate based on many economic factors, some of which include the stock market, bond market, inflation, the unemployment rate and GDP (gross domestic product), just to name a few.”

All of these rates and indices fluctuate constantly. However, certain events or market predictions will cause a large enough shift that the Fed might decide to change its rate.

When rates shift down, Earle says the cause could be when money gets “looser,” or the perceived risk in the economy decreases. On the flip side, “Rates will often rise due to market forces when there is a perception of increasing risk in the economy — say, of an impending recession — or when lendable funds get tighter, he says.”

Earle notes that the FOMC has meetings roughly once every six weeks in which it examines economic data from all over the country and decides what the outlook for inflation is.

“If it seems like the risk of inflation is increasing, they raise the Fed funds rate, which tends to raise most of the other interest rates in the economy,” Earle says. “This is done, among other reasons, to attract more money into bank accounts and away from consumption.” The Fed might lower rates to accomplish the opposite.

For example, take the Great Recession that occurred during the late 2000s, which is considered to be the biggest economic downturn since the Great Depression. Generally, the Federal Reserve aims to maintain its rate at around 2 to 5 percent. Prior to this recession, the Fed rate hovered around this benchmark. But once the economy took a nosedive, the Fed decided to lower its rate to an unprecedented 0.25 percent — effectively, zero — in order to accelerate economic recovery. Only recently has the Federal Reserve begun to raise rates again, with the first increase occurring in December 2015. As of October 2018, the federal funds rate sits at 2.25 percent, with the goal of reaching 3.5 percent by 2020.

Earle points out that the FOMC doesn’t have a crystal ball. Rather, it relies on market data to make the best guess as to how the economy will shift. These predictions don’t always turn out to be correct.

“At times, their changes in interest rates have, in retrospect, been counterproductive,” Earle says.

How Changing Interest Rates Affect You

All of this might seem pretty abstract, but fluctuations in the federal funds rate have very real consequences for you, both good and bad.

Stobbe explains that changing interest rates can affect consumers by increasing or decreasing their buying power for a variety of major life purchases, including homes, cars and even college educations. However, rate fluctuations also impact smaller purchases when they’re charged to credit cards and the balance is carried month over month. As rates increase, for example, you will theoretically be able to borrow less since more of your money will go toward interest charges.

[Read: The Best Credit Cards with High Credit Limits.]

It’s important to note that rising interest rates can benefit consumers, too, says Stobbe, through higher interest rates on deposit accounts such as savings accounts and certificates of deposit.

Earle says it takes time to see benefits. “Small changes, in a short amount of time, usually don’t have much of an effect,” he says. “But the level of interest rates over a longer time period definitely affects the consumer’s propensity to consume (spend) versus to save.”

In other words, as rates increase, your savings will earn more interest, but it will become more expensive to borrow money. On the other hand, as rates go down, you can borrow money more cheaply, but your savings will earn less.

What to Do When Interest Rates Rise

Since rates are on the rise and could be for some time, it’s important to use increasing rates to your advantage as much as possible. In a rising rate environment, it costs more to borrow money while your savings accounts will earn more.

Stobbe says if you use a credit card, it’s important to pay the balance in full each month so you don’t rack up interest charges. Credit card interest has a compounding effect, meaning that each month you carry a balance, you end up paying interest on the previous month’s interest. This can make it easy to fall into a cycle of debt, especially in a high-rate environment.

If you already have some credit card debt, Stobbe suggests you prioritize paying down the balances with the highest interest rates first. This is known as the avalanche method of paying off debt. Essentially, you put as much money as possible toward your balance with the highest rate, while making the minimum payment on all of your other accounts. Once that first balance is paid off, you take what you had been contributing and apply it toward the next-highest rate balance, and so on. This method will save you as much as possible in interest charges.

If you need more motivation, however, you can use the snowball method. Rather than tackling the balance with the highest interest rate first, you focus your efforts on paying off the smallest balance. This lets you experience a win right away and motivates you to continue tackling the next-highest balances. It will likely cost you more in the long run compared to the avalanche method, but the most important thing is choosing a debt payoff strategy that you will stick to.

But what about borrowing money? Unfortunately, if you want to take out a mortgage or finance a car, there’s not much you can do to combat rising rates other than spending less on financed purchases.

“You can choose to finance things that have the opportunity to make you money, such as commercial loans for your business if you are self-employed, and pay cash for items that are consumer purchases,” Stobbe suggests.

Improving your credit score is another strategy for saving on interest charges. Generally, the better your credit rating, the better the interest rate you can expect.

The good news for borrowers is that even if rates seem high now in comparison to recent years, they’re still historically quite low.

[Read: The Best Credit Cards for People with Fair Credit.]

As far as savings, rising rates are a good thing. Earle says, “If a (bank) customer wants to take advantage of rising interest rates, they might do well to see what savings accounts, CDs and other instruments are paying the highest rates local to them.”

Community banks and credit unions tend to offer some of the most competitive rates, as do online banks. Fortunately, there are plenty of online rate aggregators that are updated regularly that allow you to search for the highest savings rates with a few clicks.

What to Do When Interest Rates Fall

When the Fed chooses to lower rates, inflation can become a concern since lower rates are meant to encourage consumer spending and economic growth, which can spur inflation. Earle suggests choosing investments that can help you hedge against inflation, like Treasury Inflation Protected Securities, gold and commodities.

When interest rates are low, it’s also an ideal time to borrow money, such as taking out a mortgage or car loan. You can lock in a low interest rate on a fixed-rate mortgage, for example, which will help you save money on interest over the life of your loan. When interest rates are low, it’s also a good time to refinance existing debt, like your mortgage or student loan.

More from U.S. News

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