While you've probably heard about Federal Reserve interest rates, do you picture a giant question mark when this topic comes up? Spoiler alert: Federal Interest rates are a big deal and impact your daily life more than you might think.
These federal reserve rates affect everything from your mortgage to how much interest you earn on some of your investments. So, it's good to know what these rates are and exactly how they affect your finances.
Before we dive into the details, let's discuss what the Federal Reserve is first!
What is the Federal Reserve?
First things first—what exactly is the Federal Reserve (aka the Fed)? Basically, the Federal Reserve System is the United States' central bank. Its goal is to "promote the effective operation of the U.S. economy and, more generally, the public interest."
They run monetary policy that aims to maximize employment and stabilize prices. (Yep, they're the ones who control inflation). The Reserve also supports individual financial institutions and monitors how they impact the financial system as a whole.
The Fed's services help with transactions, and their research analyzes consumer issues and trends. They even delve into community economic development activities and administer consumer laws and regulations.
What are Federal Reserve interest rates?
The Federal Reserve operates based on monetary policy actions. These actions are "to achieve three goals specified by Congress: maximum employment, stable prices, and moderate long-term interest rates in the United States."
This means they can tweak how much credit is available in the economy and how much credit costs you.
Banks are most directly affected by the Fed interest rate. This is the rate that banks and other institutions that hold money use to lend money to each other. Banks legally have to keep a minimum portion of their customers' money on reserve.
Since they're not allowed to earn interest on that amount, they lend it back and forth to other institutions to stay as close to that limit as possible. Learn more about how banks work.
Commonly asked questions when the Federal Reserve interest rates change
The federal reserve interest rates affect your finances personally. But how so? Here are some common questions about what happens when there is a change in federal reserve rates.
Why do interest rates change?
So, why do interest rate fluctuations happen because of the Federal Reserve? The Fed's goal is to keep the fed rate at or near a target set by the Federal Open Market Committee (FOMC).
When the target changes—or is projected to change—interest rates paid by borrowers and earned by savers go up or down accordingly.
For example, with the onset of a recession, the FOMC lowered its target for the federal funds rate close to zero at the end of 2008. This was done to bolster the economy, making it easier to borrow and spend.
Interest rates went up again once the nation stabilized. Recently, there was a Fed rate cut down to near zero in anticipation of the financial crisis due to the COVID-19 pandemic.
The interest rate fluctuations have to do with the state of the U.S. economy. The more stable the job market and the economy, the higher the Fed raises interest rates. This is because the system—and Americans—can support it. And vice versa.
*For all you history buffs, check out this timeline.
How does the Fed rate affect me?
Something as large-scale as the central bank of America may seem too lofty to comprehend. Still, the Fed's actions can have a substantial impact on your life. Interest-bearing savings accounts and certificates of deposits may earn less when Fed interest rates are low.
What happens to mortgage rates when the Federal Reserve raises rates?
The federal reserve doesn't directly set mortgage interest rates, but a change in the federal reserve rates impacts the costs of banks to borrow from other banks, which translates into the cost of mortgage loans.
For example, if you're buying a home when interest rates are low, try to lock it into a fixed-rate mortgage. If you borrowed when interest rates were high, consider refinancing when rates are lower if the costs work out in your favor.
How will federal reserve interest rates affect my current mortgage?
Existing mortgages are long-term loans, and if you have a fixed rate, then a change of interest rate will not affect you. However, suppose you have an adjustable-rate mortgage (ARM).
In that case, your interest rate could increase or decrease "at the next reset." Of course, there are rate caps that can control how much your rate is adjusted. These rate caps are:
- Initial adjustment rate cap: This is a cap for how much the interest can increase after the initial fixed-rate matures.
- Subsequent adjustment cap: This caps the interest for the following adjustment periods.
- Lifetime adjustment cap: This is how much the interest can be raised over the life of the loan.
HELOCs (home equity lines of credit) are also affected when federal reserve interest rates increase and decrease. This is because they usually have variable interest rates, which will affect your payment amounts.
Make sure you can afford the payments before taking out a HELOC if the fed interest rate were to rise!
What do low Federal Reserve interest rates mean for homebuyers?
The best time to purchase a home is when mortgage rates are low. Why? Because the cost of financing a home is cheaper in terms of the amount of interest you pay to the lender. This can save you tens of thousands of dollars in interest over the life of your loan.
So, if you are considering purchasing a home, try to wait if possible to get the lowest rate. Of course, your mortgage rate also depends on your credit score, down payment, and more, but you will get the prime rate when the fed interest rate is at its lowest.
How do low-interest rates affect consumers?
Low rates mean that people earn less interest on their savings. This tactic encourages consumers to spend instead of saving money. This change of interest rate is commonly done to stimulate the economy for economic recovery.
Since interest rates are low, more people are willing to borrow money to buy higher-priced items, such as homes, cars, etc. Therefore, this means more shopping and spending money which essentially boosts the economy, leading to economic growth.
Will the Federal Reserve raise interest to a higher rate?
We typically experience higher interest rates as the economy rebounds and becomes strong enough to handle the extra interest, especially after recent fed rate cuts to support that rebound.
However, an interest rate hike on federal interest rates is likely to affect all types of loans and credit lines. For example, home equity lines of credit, credit cards and other types of credit lines, student loans, mortgage, and car loans will be impacted by higher rates.
If a hike is coming, they are usually announced by the Chair of the Board of Governors of the Federal Reserve System.
Will interest drop to a lower rate?
It's always likely there could be a higher interest fed rate in the near future. The Fed constantly changes rates, so there is some uncertainty about what the rates will do long term.
Will there be another Fed rate cut? No matter what happens with the interest rate fluctuations, it does affect you, and it pays to know what's going on.
To see an interest rate chart with historical information starting from 1955, see this one from FRED Economic Data.
Federal Reserve interest rate changes affect your finances!
So, now you know the answer to "why do interest rates change?" While Federal reserve interest rates are not the be-all-end-all of your financial well-being, interest rate fluctuations or a Fed rate cut can have an effect on major and minor aspects of your personal wealth.
The key is to use the change of interest rates to your advantage whenever possible. Pay attention to economic activity and economic indicators, as well as the federal reserve rates, so you know when something changes.
Keep in mind it's best to do your utmost to get out of debt, stick with a budget, and make smart money moves. Learn how with our completely free "Build a solid foundation" bundle! Also, subscribe to the Clever Girls Know podcast and YouTube channel for money tips and hacks!