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How Federal Interest Rates Work

Casey Bond

If you've ever carried a credit card, borrowed money or stashed some cash in a savings account, you know that interest rates affect how many dollars stay in your pocket. A complex system dictates interest rates at any given time. Here's more on how rates are determined.

How Do Interest Rates Work?

In essence, interest rates can be thought of as the price of borrowing money.

"Quite simply, it's the amount charged by a lender for use of an asset, expressed as a percentage of the principal value," says Peter C. Earle, economist, writer and researcher at the American Institute for Economic Research.

Assets borrowed could include cash, cars or properties.

Interest rates work differently, depending on whether you have a credit card, a loan or a bank account.

[Read: Best Low-Interest Credit Cards.]

Most credit cards come with an interest rate that is expressed as an annual percentage rate, or APR. A credit card can either have a fixed APR or a variable APR for purchases that will be based on your credit score.

Whenever you take out a loan, the lender will charge you interest as a cost of doing business. If you open a savings account, the bank pays you interest for keeping your funds on deposit, which it can then use to make loans.

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

What Is the Federal Interest 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 falls under that amount, it can borrow funds from another bank to meet the requirement. The interest rate banks charge each other to borrow money overnight is called the federal funds rate.

The Fed controls this rate, Earle explains. Specifically, the Fed's Open Market Committee, or FOMC, sets it.

Banks base the interest rates they offer consumers on the Fed's rate. For example, the rate that banks and other financial institutions charge their lowest-risk customers is called the prime interest rate. This rate is generally 3 percentage points higher than the Fed rate. Essentially, the prime rate is the best possible interest rate you can get when you borrow money, and you can expect higher rates if your credit isn't ideal.

That means the Fed rate directly affects consumer interest rates, such as those on home equity lines of credit, credit cards and car loans, according to Earle.

The Fed's interest rate is also used as a benchmark for setting the interest rates you can earn on deposit accounts. That includes savings and money market accounts and certificates of deposit. Generally, deposit rates rise and fall along with the Fed's rate.

What Is the Interest Rate Today?

U.S. interest rates have been on a roller coaster ride over the past few decades. After soaring into the double digits in the 1980s and reaching as high as 20%, the federal funds rate dropped to nearly zero during the financial crisis in December 2008.

"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 (gross domestic product), just to name a few," says Elysia Stobbe, mortgage and real estate expert and author of "How to Get Approved for the Best Mortgage Without Sticking a Fork in Your Eye."

All of these rates and indexes fluctuate constantly. But certain events or market predictions could lead the Fed to adjust the rate.

When the rate shifts down, Earle says, money gets "looser," or the perceived economic risk of making borrowing cheaper 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 meets roughly once every six weeks to examine U.S. economic data and assess the inflation outlook.

"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. Take the Great Recession of 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 about 2% to 5%.

Only recently has the Federal Reserve begun to raise rates, with the first increase occurring in December 2015. As of October 2018, the federal funds rate sat at 2.25%, and the Fed said it planned to keep increasing its rate to 3.5% by 2020. But for the first time since the global financial crisis, the Fed decided to cut rates again, and they are set to hover between 2% to 2.25%.

Earle points out that the FOMC doesn't have a crystal ball. Rather, it relies on market data to make a best guess on 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.

[Read: Best 0% APR Credit Cards.]

How Do 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. Some are good and some are bad.

Stobbe explains that changing interest rates can affect consumers by increasing or decreasing their buying power for major life purchases, such as a home, a car and even a college education. Rate fluctuations also influence smaller purchases when you charge those items to credit cards and carry the balance month over month. As rates increase, for example, you will theoretically be able to borrow less because more of your money will go toward interest charges.

But rising interest rates can benefit consumers, too, Stobbe says, through higher interest rates on deposit accounts such as savings accounts and certificates of deposit.

Seeing benefits from a rate increase can take time, Earle adds. "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 (spend) versus to save."

In other words, as rates increase, your savings will earn more interest, but borrowing money will become more expensive. As rates go down, you can borrow money more affordably, but your savings will earn less.

What Should You Do When Interest Rates Rise?

When rates are on the rise, use this to your advantage as much as possible. Here's what you can do, depending on whether you have credit cards, loans or savings accounts.

Credit cards: If you use a credit card, make sure you pay the balance in full each month so you don't rack up interest charges, Stobbe says. 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 have credit card debt, Stobbe suggests paying down the balance with the highest interest rate first. This is known as the avalanche debt payoff method. You put as much money as possible toward your balance with the highest rate, and make minimum payments on your other accounts. Once that first balance is paid off, you apply that payment amount toward the next highest-rate balance, and so on. This method will save you as much as possible in interest charges.

If you need motivation to stay on track, you can use the snowball payoff method instead. 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 inspires you to tackle the next-highest balance. It will likely cost you more in the long run compared with the avalanche method, but choosing a debt payoff strategy that you can stick to is more important.

Loans: Unfortunately, if you want to take out a mortgage or finance a car, you cannot do much to combat rising rates other than finance fewer 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.

[Read: Best Balance Transfer Credit Cards.]

The good news for borrowers is that even if rates seem high compared with recent years, they are still historically low.

Savings accounts: As far as savings, rising rates are a positive. 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, plenty of online rate aggregators that are updated regularly let you search for the best savings rates with just a few clicks.

What Should You Do When Interest Rates Fall?

A Federal Reserve cut to interest rates is meant to encourage consumer spending but can spur inflation. Earle suggests choosing investments that can help you hedge against inflation, such as Treasury Inflation-Protected Securities, gold and commodities.

When interest rates are low, this can be an ideal time to borrow money for 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. It's also a good time to refinance a mortgage or student loan.



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