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Federal Reserve Interest Rates Explained

March 31, 2020 · 7 minute read

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Federal Reserve Interest Rates Explained

Anyone keeping an eye on the news lately—and who hasn’t?— has probably seen the Fed come up a time or two. In response to a stock market spiraling in the face of COVID-19, the Fed has cut its interest rates swiftly and seriously, to a low of just 0.25%.

But consumers may be wondering how, exactly, this new low will affect their personal finances, which are more than likely in a tailspin of their own. They might also be wondering what, exactly, the Fed is and how it affects the national economy.

Here’s what consumers should know about the Federal Reserve interest rate, and how it trickles down to the level of individual wallets.

Responsibilities of the Federal Reserve?

“The Fed” is short for the Federal Reserve System, which is the central US bank. The Fed as a whole is made up of a dozen smaller banks, each of which is localized to a specific geographical region in the country.

The Federal Reserve is responsible for a variety of financial duties that keep the country’s economy safe and stable. These duties include:

•   Supervising and regulating smaller banks.
•   Conducting and implementing national financial policies.
•   Maintaining widespread financial stability, in part by setting interest rates.
•   Providing financial services like operating the national payments system.

The Fed was founded in 1913, when the Federal Reserve Act was signed into law by President Woodrow Wilson.

There have been some decidedly unstable times since its inception, including the Great Depression and the housing market crash of 2008.

Still, the Fed works to help balance the economy over time—and its actions and influence on monetary policy can have an affect on individual wallets.

In the context of world news, particularly in the wake of the coronavirus pandemic, the headlines about the Fed centralize on its changing interest rates. (In short, the Fed has recently cut rates to nearly 0% in the face of this global crisis.)

So what does that rate cut mean for personal finances? Take a deeper look at how the Fed influences the economy and how its interest rates work.

How The Fed Influences the Economy

The Fed is the main regulator of the US banking system. Along with setting its target interest rate, the Fed also has other powers—more so than regular banks—to take measures to ensure systemic financial stability.

For instance, the Fed has authority over other US banking institutions and can regulate them in order to protect consumers’ financial rights.

The Federal Reserve Bank of San Francisco lists both examining and monitoring banking organizations on its list of supervisory duties, as well as evaluating a banking organization’s capital adequacy (i.e., amount of available cash) and risk profile.

That means the Fed has a hand in keeping consumers safe in their banking experiences. But perhaps its most famous job is setting its interest rate, otherwise known as the federal funds rate.

The federal funds rate is not directly connected to consumer interest rates, like those that might be paid on a personal loan or home loan.

But it can have a major influence on those interest rates, and over time has the ability to impact how both businesses and individuals access lines of credit.

How Does the Fed Affect Interest Rates?

To understand the effect of a Fed rate cut on the level of the consumer, we first need to understand what, exactly, the federal funds rate is—and what cutting it means.

The federal funds rate, or federal interest rate, is a target interest rate that’s assessed on the bank-to-bank level.

That is, it’s the rate at which banks charge each other for loans borrowed or lent on an overnight basis. (Psst: looking for more definitions to some of the tricky verbiage surrounding the Fed? Check out this Federal Reserve cheat sheet.)

Banks may need to borrow money in order to meet the minimum level of reserves they’re normally required to have by law.

These minimums can be kept either as vault cash or as reserves within The Fed, and the exact amount required varies—though the minimum generally sits around 10% of the total value of the bank’s checking accounts.

(In response to COVID-19, the Federal Reserve announced the elimination of this reserve, effective March 15, 2020. It has not yet been decided how long this change will be in effect.)

The federal funds rate is set by the FOMC, or Federal Open Market Committee , at a minimum of eight times per year—though the committee will meet more often than that if deemed necessary.

And although this rate doesn’t have a direct influence on the interest levels for loans taken out by consumers, it can work to change the dynamics of the economy as a whole through a kind of trickle-down effect.

Thus, the Fed often slashes rates as a response to turmoil in the market as an attempt to boost the economy. Lower rates may make it easier for businesses and individuals to take out loans and thus create more cash flow.

On the other hand, the Fed may raise interest rates when the economy is strong in order to keep borrowing in check, which can help prevent the kind of inflated market that can lead to crises like we saw in 2008.

The Fed’s rate changes have an impact across a broad swath of financial areas, from credit cards to mortgages to savings rates and even life insurance policies. The Fed’s rate change can affect individual consumers in specific ways.

The Prime Rate

One of the most important financial factors a change to the federal funds rate can influence is the prime interest rate, also known as the Prime Bank Loan Rate .

The prime interest rate is the interest rate banks offer their most creditworthy customers when they’re looking to take out a line of credit or a loan.

While each bank is responsible for setting its own prime interest rate, many banks do choose to set theirs based in large part on the federal funds rate.

Generally, the rate is set approximately three percentage points higher than the federal funds rate—so, for example, with the rate currently at 0.25%, a bank’s prime interest rate might be 3.25%.

Even for consumers who don’t have excellent credit, the prime interest rate is an important figure. It’s the baseline from which all of a bank’s loan tiers are calculated.

That goes for a wide range of financial products, including mortgages, credit cards, automobile loans, and personal loans. It can also have an effect on existing lines of credit that have variable interest rates.

Savings Accounts and Certificates of Deposit

Interest rates bend both ways. Although a federal rate cut may mean a consumer enjoys lower interest rates when borrowing, it also means the interest rates earned through savings, certificates of deposit (CDs) and other interest-bearing accounts will drop.

This decrease in interest earnings is no reason to pull out of a savings plan entirely in most cases, because it is important to maintain an emergency fund.

But it could be a good opportunity to use any excess funds to pay off existing debts while interest rates might be lower than usual.

The Stock Market

While the federal funds rate has no direct impact on the stock market, it can have the same kind of ripple effect that is felt in other areas of the US financial system.

Generally, lower rates make the market more attractive to investors, since lower interest rates mean they may have more capital to allocate.

Plus, consumers spending more may mean good performance (and thus higher earnings) for the companies issuing shares of stock.

On the other hand, an increased rate tends to lead to a slight downturn in the market, for all the same reasons listed above—but in reverse.

As consumers have less money available to spend or invest, existing investments may fall in value and investors may be less inclined to allocate more assets, and may even sell some of their holdings. (An exception to this rule are stocks in the financial sector, since these companies may be earning more money because of an uptick in outgoing loans.)

Other Factors Affecting Consumer Interest Rates

Although the Federal Reserve interest rate is an important factor in a variety of personal finance matters, it may take up to twelve months to feel the full effect of a change.

And it’s also only one piece of the answer to the larger question, “How are interest rates determined?”

On a consumer level, interest rates for credit cards and loans are calculated using a complex algorithm, which takes everything from personal creditworthiness to loan convertibility into consideration. Banks use benchmarks to determine an individual’s interest rate.

Credit History and Credit Score

Individual factors have a profound effect on interest rate, and one of the easiest ways for banks to assess those factors is via credit reports and credit scores.

One of the most commonly used credit scores is the FICO® score, issued by the Fair Isaac Corporation, which expresses creditworthiness with a three-digit score from 300 (“very poor”) to 850 (“exeptional”).

The FICO® score, as are many other scores like it, is calculated based on an individual’s financial history and behaviors, such as on-time payments, overall credit usage, different types of credit used, and other factors.

A higher credit score may lead to lower interest rates, whereas a lower credit score might drive your interest rates higher.

Loan Term

A loan’s term refers to the length of time over which a borrower repays the debt. Sometimes, shorter-term loans might have a higher interest rate, whereas a longer-term loan may carry a lower rate.

That said, it’s still a good idea to calculate how much interest will be paid over the entire lifespan of the loan, as the lower interest rates on longer loans don’t necessarily mean the total interest paid will be lower.

Secured vs. Unsecured Loans

Consumer loans generally come in two varieties: secured and unsecured. Secured loans are those tied to a security, or tangible asset, which the bank can repossess if the borrower does not pay the debt.

For instance, auto loans are secured loans because the vehicle itself serves as collateral.

On the other hand, an unsecured loan, like a personal loan, doesn’t have such a failsafe for the lending institution—which means it may carry a higher interest rate than a secured loan.

Convertibility and Competition

Along with the factors specific to the loan and borrower, banks and lenders must also take into consideration market-based factors, such as competition amongst other banks, variabilities in consumer spending, inflation, and even changes in the national debt and GDP.

Like other businesses, banks are always looking to maximize profits for their shareholders while offering low enough rates to incentivize consumers to buy their financial products.

Investing in a Low Interest Rates Environment

Although it can be scary to put money into the market when all trend lines appear to be on the downslope, a bear market can actually be a good opportunity for long-term investors.

When the market corrects itself, assets purchased at low prices might increase in value, resulting in valuable profits.

And with the Fed’s recent interest rate cuts, investors can be cautiously optimistic about the market’s future. Although no investment comes without risk, investing remains one of the most powerful ways to build wealth over time.

SoFi Invest® offers both active and automated investing options. For both experienced investors and those who might just be dipping their toes into the world of investing, SoFi has a plan that can work with most goals.

Download the SoFi App to stay to up to date with the market and to get started investing.

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