In their March 2022 meeting, the Federal Reserve raised interest rates for the first time since 2018, over a year before the coronavirus pandemic began. But what does it actually mean when the Fed raises interest rates — or lowers them, as it did when the pandemic first hit the U.S.?
You’re not alone in wondering. Federal interest rates seem like they should be intuitive, yet they’re anything but.
Here’s what you need to know about federal interest rates — without the fancy finance lingo.
What Is the Federal Interest Rate?
The federal interest rate, more accurately known as the federal funds rate or fed funds rate, is a target interest rate for banks to lend money to each other overnight. It serves as a baseline for all loans across the economy.
In other words, the federal funds rate is usually the cheapest that anyone lends money in the U.S. All other commercial and consumer loans come with a premium on top of this target rate.
This benchmark interest rate is set by the Federal Open Market Committee (FOMC) — the policymaking body of the Federal Reserve or Fed — at each of its eight yearly meetings.
How the Federal Interest Rate Works
By law, banks must hold a certain amount of cash at all times. This minimum cash reserve is based on a percentage of their deposit accounts. Banks must keep this reserve requirement deposited in a Federal Reserve bank.
Because millions of dollars flow in and out of each major financial institution every day, banks can end the day with more or less money than they need by law. To correct these imbalances, they lend money to each other, typically at the federal funds rate.
As you can imagine, banks are about the safest borrowers on the planet. As a consumer, you’re a lot riskier than a bank is. That’s why lenders charge you a premium on top of the fed funds rate. For example, if the federal interest rate is 1%, your bank might quote you a 4% mortgage interest rate, a 5% auto loan rate, and a 20% credit card rate.
Each of these types of credit comes with different risk levels for lenders, so they charge differently for them. People default on credit card payments far more often than car loan or mortgage payments, hence higher credit card interest rates.
Why the Federal Reserve Raises or Lowers Interest Rates
Interest rates are one of the ways that the Federal Reserve can stimulate or cool down the economy.
Low interest rates encourage borrowing, making it easier for both businesses and consumers to spend money on goods and services. When consumers spend more, businesses earn more money. When businesses earn more money, they hire more workers, and invest more in developing and promoting their existing employees.
So why would the Fed ever want to suppress that kind of economic growth?
Why the Fed Raises Interest Rates
When the economy overheats, bubbles form.
Consider the housing bubble that burst in 2008. To oversimplify, mortgage loans were too cheap for too long. Several factors were responsible for this, including the way that investment banks packaged them for sale to other investors and the way that credit agencies underrated their risk. Low interest rates, particularly on adjustable-rate mortgages to borrowers with weak credit, made mortgage payments cheaper, so buyers could afford to spend more on houses. That artificially inflated home prices during the mid-2000s.
When rates went up, it pushed those adjustable mortgage payments skyward. Borrowers started defaulting, foreclosures started flooding the market with cheap homes, and housing prices collapsed. In other words, the bubble burst.
Avoiding bubbles and market crashes isn’t the only reason the Fed raises interest rates to cool economic growth. They also raise interest rates to cool down inflation. They aim for a steady inflation rate of around 2% per year.
Out-of-control hyperinflation can ruin economies, companies, individuals’ savings, and entire countries. Even lower rates of inflation can seriously erode your long-term savings if you leave your money in cash and don’t invest in inflation-resistant assets.
Ultimately, higher interest rates discourage borrowing, encourage saving, and cool down the economy — bringing inflation down with them.
Finally, the Federal Reserve raises interest rates because they need some room to be able to lower them when it’s time to spur economic growth. If they leave rates near zero forever, they lose one of their few real tools to boost the economy.
Why the Fed Lowers Interest Rates
The Fed lowers interest rates when the economy lags and needs a shot in the arm.
It makes borrowing cheaper, encouraging people and companies to borrow in order to spend more. Spending more fuels our consumer-driven economy and makes it easier for companies to take out loans to grow their businesses.
That’s why commentators talk about interest rates as a “lever” that governments can use to heat up or cool down their economies as needed.
How the Federal Funds Rate Affects You
The fed funds rate affects you in many ways, some more direct than others. Whenever you hear news of the Fed lowering or lifting interest rates, you can expect the following impacts on your financial life.
Credit card companies tend to move their card pricing to align with federal interest rates. As the fed funds rate rises or falls, so do credit card interest rates.
This reflects a broad underlying trend among most creditors. They charge a premium over and above the fed funds rate, whatever that happens to be at the moment.
Likewise, loan providers shift their pricing up and down to keep pace with the fed funds rate.
Nowhere is the linkage between the fed funds rate and consumer interest rates more obvious than in the mortgage loan industry.
Prime mortgage interest rates — those reserved for borrowers with very good credit scores — tend to cost around three percentage points more than the fed funds rate. Meanwhile, home buyers with bad credit might pay five or six percentage points more.
Mortgage rates constantly shift based on market conditions and other forces. They also respond to other benchmark interest rates that the Federal Reserve doesn’t directly control, such as the interest rate on 10-year U.S. Treasury bonds. However, mortgage rates always remain closely correlated with the fed funds rate.
Banks set savings account interest rates based on federal interest rates as well.
Even the highest-yield savings accounts rarely pay much more than the fed funds rate. The same goes for certificates of deposit (CD) accounts, money market accounts, and other depository accounts. In low-interest environments, these accounts may pay less interest than the inflation rate. That means money left in them can actually lose value over time after accounting for inflation.
The federal funds rate particularly impacts bond yields, which in turn impact bond prices.
Federal, state, and local governments all price their bonds roughly based on the fed funds rate. So when the federal funds rate goes up, newly issued bonds pay higher yields. That makes older, lower-paying bonds less valuable on the secondary market, so prices for existing bonds go down.
In other words, rising interest rates are good news for investors buying new bonds but bad news for sellers already holding bonds in their portfolios.
How to Prepare for Higher Interest Rates
When interest rates rise, borrowing becomes less attractive, while investing in stocks becomes more so.
Lock in Low Rates Before They Raise
If you have an adjustable-rate mortgage (ARM), consider refinancing into a low fixed-rate mortgage before interest rates rise. You can leave that loan in place for the next 15 to 30 years, and never touch it again.
Alternatively, if you’ve been thinking about taking out an auto loan, personal loan, or business loan, consider doing so now before rates go up.
Save More, Spend & Borrow Less
As the Fed raises interest rates, aim to boost your savings rate and take advantage of higher yields. Do this by spending less and investing more.
Higher interest rates reward savers and investors while penalizing borrowers. Unless absolutely necessary due to an unexpected financial emergency or life change, don’t take out additional debt once interest rates start their liftoff.
Pay Off Credit Cards
Credit card interest rates often fluctuate along with the fed funds rate. If you carry a balance, aim to pay it off once and for all before rates rise.
Of course, you don’t want to carry a balance from one month to the next even when rates are low. Credit card companies still charge a massive premium on the fed funds rate, making credit card interest outrageous even in the best of times.
Consider Leaving Old Low-Interest Loans Open
Imagine you borrowed a mortgage at 3% interest when rates were low. A few years later, interest rates have risen, and now you can invest your cash in low-risk investments that pay 4%, 5%, 6% or more.
You have some extra cash each month, and you’re trying to decide whether to put it toward paying down your mortgage or investing it elsewhere. Paying off your mortgage early is the ultimate risk-free investment because it offers you a guaranteed return equal to your interest rate. But if you could earn 6% on an extremely low-risk municipal bond, you’d get double the return with only slightly more risk.
Invest in Cash-Rich Companies
Rising interest rates drive up borrowing costs. That pinches heavily leveraged companies dependent on a steady supply of credit.
Not every company carries high debts — or any debts at all, for that matter. If you like picking individual stocks, look for companies with low debt-to-equity (D/E) ratios. Unlike companies carrying heavy debt loads, they stand to gain from higher interest rates.
Consider Bond or CD Ladders
If you believe interest rates will continue rising, consider buying a series of short-term bonds or CDs so that as each one matures, you can reinvest the money in a new higher-interest bond or CD.
Called a bond or CD ladder this strategy helps you take advantage of rising interest rates over time.
Prepare for a Recession
Rising interest rates sometimes pave the way for recessions. You want to get your financial house in order while the economy still has steam.
Beyond reducing your debts and building your emergency fund, pay particular attention to your income. How safe is your job? Have you been thinking about a career change anyway? Double down on your work-related networking while sprucing up your resume.
Whether a recession comes or not, you can at least position yourself better for a career move, whether for a raise or to better match your ideal lifestyle.
How to Take Advantage of Lower Interest Rates
Lower interest rates offer a different set of opportunities and risks. Keep these tips in mind when the Fed signals lower interest rates on the horizon.
Lock in Low Rates After They Fall
As the corollary to the advice above, consider buying a home or refinancing your current mortgage once interest rates drop. Take out a 15- or 30-year fixed rate mortgage to lock in the low interest rate for the life of your loan.
That said, avoid timing the market. If you’re ready to buy a home now, don’t hold off just to wait for lower interest rates. Lower interest rates could simply drive up home prices further.
Invest in Real Estate
Consider Borrowing to Grow Your Business
When borrowing becomes cheap, it offers an opportunity for small businesses to get the capital they need to expand.
That could mean adding employees to grow your marketing efforts or expand into new markets. Just beware that debt also adds risk in your business, even if you can borrow inexpensively.
Look for Bond Alternatives
In low-interest environments, bonds just don’t pay well.
In my own quest for financial independence and early retirement, I’ve looked elsewhere for passive income sources. Beyond rental properties, I also invest for real estate cash flow in other ways. I buy shares in real estate crowdfunding platforms such as Fundrise and Streitwise. I buy public real estate investment trusts (REITs). I invest in hard money loans secured against real estate, both directly and through platforms like Groundfloor.
Go beyond real estate and look to stocks as well. Check out exchange-traded funds (ETFs) that offer high dividend yields for ongoing income.
Invest for Growth
The Federal Reserve lowers interest rates to stimulate economic growth. While this doesn’t always work, it often does.
Consider investing in industries with high growth potential, such as technology. You don’t need to pick individual stocks — just buy shares in growth sector ETFs. Or just buy shares in broad index funds that mirror major stock indexes.
Over time, the stock market returns around 10% per year on average. The risk of default on U.S. Treasury bonds might be minuscule, but that’s barely treading water when they only pay 2% per year. After all, the Fed’s target inflation rate is about 2%.
You can look abroad for growth opportunities as well. As someone who has lived in several developing countries, I believe that the majority of the economic growth for the rest of this century will come from emerging markets. Accordingly, I invest more in emerging market ETFs than the typical American as well.
The cost of borrowing just about any type of loan ties closely to the federal funds rate. That means that the fed interest rate directly affects your personal finances.
But it’s not the only factor that affects the interest rate you pay for borrowing money on a home loan, car loan, or credit card. You can become a more attractive borrower by increasing your credit score, boosting your savings rate, and increasing your cash reserves.
With a higher credit score, you’re more likely to score the best loan terms available — no matter what the federal interest rate is.