Have you ever heard about the federal funds rate? You might be more familiar with interest rates. Interestingly, it has a close relationship with the interest rate. Therefore, you need to understand more about this thing. You will get more benefits from it, especially when you plan to apply for a mortgage or personal loan.
This article will help you understand more about what the federal funds rate is, how they determine the rate and other information that will be a reference for your loan plan. So, please stay longer and read until the end of the article. Guaranteed, you will get new knowledge that helps you to create a better plan to get the loan you need.
What is the Federal Funds Rate?
Let’s start with the federal funds rate definition. What is the federal funds rate? In short, it is an essential tool for the bank to set the interest rate. The bank we are talking about here is the Federal Open Market Committee (FOMC). It is one of the bank systems in the Federal Reserve.
How Does the Federal Funds Rate Work?
As mentioned earlier, the federal fund rate is a guideline to set the interest rate for the loan program. The more precise term might be the target rate for how much the interest rate will be. It means the Federal Fund rate becomes the limit on the highest and lower interest rate that banks can use.
FOMC applies it as the guidelines for every bank regarding the total capital that they have daily. As you might already know, every day, the amount of money that flows into the bank system is changing fast. Every day, customers deposit and withdraw their money at the banks. This money flow provides the banks with enough capital they can use to provide loans and other forms of credit to the clients.
However, without proper guidelines, the flow of money and loan applications could harm the bank’s stability and solvency. Therefore, the bank needs to use the interest rate to ensure they have enough capital to continue to operate. Furthermore, the bank will use the federal funds rate set by FOMC to determine how much interest rate they can apply to the loan. The bank is not allowed to exceed the upper and lower limit of the rate.
How is this rate implemented in the loan interest rate? Here is an example of a simple case. A bank offers a loan to its clients. Depending on the client’s credit rating, they could receive a prime interest rate. So, if the federal funds rate is 2%, the prime interest rate would be around 5%. Most banks apply a three percent higher for their prime rate than the federal funds rate.
The prime interest rate itself acts as the starting point of the interest rate from that bank. It can be said the lowest limit that banks can give to their customers. Therefore, this prime interest rate is only available for clients with good or highest credit ratings. The standard interest rate from that bank will be higher than the prime rate.
On the other hand, the federal fund rate is also known as the overnight rate because it has a fast change pace. Because of this nature, the loan interest rate (prime and standard rate) also can change much faster. It is because the bank must follow the federal fund rate strictly. Therefore, you can easily track the loan interest rate from the bank by looking at the current fed funds rate. It helps you to plan out your loan precisely.
The Federal Funds Rate and Federal Discount Rate
Other than the federal funds rate, we also can find the federal discount rate. The federal funds rate is a limit that every bank needs to have regarding its total deposit. It becomes the standard number of the capital which allows the bank to operate every business day. Many banks try to reach this limit as close as they can to ensure they are not breaking the law set by the government, in this case, the Federal Reserve.
On the other hand, the Federal Reserve also sets a similar interest rate to the bank that borrows directly from the Fed to make sure they follow the rule based on the federal funds rate. This loan interest rate is what we call the federal discount rate.
Even though it is called a discount rate, the amount is not lower than the federal funds rate. In most cases, the percentage of the federal discount rate is higher. The Fed uses this setting to encourage the bank to borrow from other financial institutions. It can stimulate the financial activity in the country, which could boost development and improve economic conditions.
How Federal Funds Rate Affect People
Because it has relation to the interest rate, the federal funds rate affects many aspects of our life. Most of them are related to financial tools and systems. Here are examples of that.
- Credit Cards
The federal funds rate affects credit card interest rates almost directly. As we explained previously, you can get the prime interest rate, if you have better credit ratings. The prime interest rate is much lower than the standard interest rate used by the loan issuer. This system is also available in the credit card system.
The change in the federal funds rate will also affect the interest rate of your credit card. It means that when the federal funds rate declines, you can expect that your credit card interest rate will also decline. However, in most cases, it won’t change that much.
- Auto Loans
The amount you have to pay for your auto loans also could be affected by the federal funds rate. In many cases, the lender uses your personal credit history to decide the interest rate. This loan lends the clients an object they will use and could be in a high-risk situation. Therefore, it is more to the capability of the lender to pay off the product, in case the product got damaged.
However, auto loans are also one of the financial products that are included in the bank system. Therefore, the federal funds rate will also affect its interest rate. Many companies that offer auto loans products will also follow the federal funds rate to ensure they comply with the law.
- Personal Loans
Personal loans mostly have a short-term policy. Therefore, it is difficult to see how the federal funds rate affects the interest rate of personal loans. However, the data has shown that there is indeed a change in the interest rate of personal loans that follows the fed funds rate.
- Student Loans
Student loans are also one of the loan types that will be affected by the change in the federal funds rate. However, it depends on the type of product that you use. Some student loan products have fixed-rate. That means their interest rate doesn’t change much because of the federal funds rate changes. Mostly, fixed-rate student loans are those issued by the government. You can find it under the name of federal student loans.
As for private student loans, they could have a fixed-rate or variable rate. The fixed rate will most likely have the highest interest rate above the federal funds rate. If you want to see the change affected by the federal funds rate, you can find it on the variable-rate student loan type.
How Federal Funds Rate Affect Mortgage Loans
Property is well-known as one of the most valuable assets you can have. It always has a high demand. The value also keeps growing from time to time. Therefore, many loans use the property as collateral. Because of that, the loan products you can find today are traded as Mortgage-Backed Securities (MBS). So, what is its relation with the federal funds rate?
In actuality, it is difficult to find the relation between those two. It has a relation, but it is not that direct. To start with, the Fed doesn’t aim to improve mortgages with its federal fund rate. Mostly, the mortgage rate is affected by the 10-year treasury yields.
However, the Fed has a unique system that uses a similar pattern to macroeconomic patterns. Therefore, when they decide the federal funds rate, it will indirectly influence the monthly budget of its system. It includes adjustable-rate mortgages (ARMs) and Home Equity Lines of Credit (HELOCs).
We can say that sometimes the mortgage rates and federal funds rates move in the same direction. However, most of the time, both of them move in different directions. When the federal funds rate is not increasing, the mortgage interest rate could increase without warning.
The Federal Funds Rate Statistics
Now, let’s see some statistics related to the federal funds rate. The first part you have to know is the current federal funds rate. As the overnight basis benchmark, the number of this measurement could change immediately. Therefore, you should know the changes and the current rate, so you can also find out the approximate interest rate of your loan.
The current fed rate is decided by the Fed through its economical policy. To find out more about it, you should know the history of the federal fund rate change, especially during the pandemic. At that time, the national economic situation was affected badly.
On March 15, 2020, the Fed set the federal funds rate at 0-0.25%. The Fed decided on this number to stimulate the economy that was affected negatively by the COVID-19 pandemic. Many businesses closed down and stopped running. So, with a lower federal funds rate, they hope it also affects the loan rate from the bank. So, the business owner can get fresh funds to recover.
Once the pandemic situation gets much better in 2022, the Fed also makes other changes. On May 5, 2022, the Fed increased the rate to 0.75-1.00%. This number was the largest fed rate increase since 2000. The Fed decided on this number to reduce the inflation levels which could bring another problem to the country.
The federal funds rate changed once more on July 27, 2022. The range becomes 2.25% to 2.5%. Compared to the previous range, this range is 0.75% higher, which shows that the country needs to do something to deal with the inflation that becomes even more severe.
Within a half year, the federal fund rate has increased by more than 1.00%. And, many experts predict that the increase won’t be stopped. At least until the end of 2022, the Fed might have increased once more to face the global inflation that could happen in 2023.
Can we find the daily federal funds rate? Unfortunately, we can’t find that. Even though banks use it daily for interest rates, the change could happen according to the economical situation in the country or the world. Therefore, the fed funds rate today will be the same as the last change announced by the Fed on July 27, 2022, which is from 2.25% to 2.5%. You can use this range to make your next financial plan.
FAQ for Federal Funds Rate
- Do I get a lower interest rate from the lender when the federal funds rate drops?
The federal funds rate is only a benchmark that determines the stability of the financial institution. Therefore, the Fed doesn’t require any financial institution to follow the federal funds rate. But, it becomes the guidelines that can make them survive in the business.
- Who are the FOMC members?
FOMC consists of a 12-member body and members that change frequently. They are the members of the Boards of Governors of the Federal Reserve System, including the Fed presidents.
- What affects the federal funds rate increase?
It is the amount of reserve available in the funds market.
Conclusion
The federal funds rate holds a significant role in this country’s economy. It affects many aspects of it, including loans and business, also the price of products. Therefore, it is necessary for anyone who has a plan to make a financial move to learn more about the federal funds rate.