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There’s no shortage of news coverage anytime the Federal Reserve (aka “the Fed”) announces its plans to manipulate interest rates — and for good reason. Aside from being the nation’s central bank, the Fed is essentially the gatekeeper of the U.S. economy.
And while the Fed remains a mystery to many people, it plays a critical role in the day-to-day lives of every family in the U.S. Its actions have an almost real-time effect on the costs of borrowing and the rate at which your savings earns money. So the Fed deciding to change interest rates does actually matter.
Of course, your life probably won’t come to a screeching halt if the Fed announces plans to lower or raise interest rates, but it will likely be impacted. Credit cards, savings accounts, loans, and mortgages all have some relationship to what the Fed does, so a change in the federal interest rate will likely have an effect on your wallet.
If you lift the curtain and take a look at what the Fed is actually doing, its impact on your life won’t be as mysterious. So, what do you say we take a peek?
What is actually happening when the Fed changes the interest rate?
Historically, the Fed’s monetary policy has been governed by what is commonly referred to as a “dual mandate.” This means the Fed has two goals: to keep inflation stable and create labor-market conditions that provide jobs for anyone who wants them. In other words, maintain stable prices and keep unemployment low.
To pursue these goals, the Fed has typically relied on interest rate policy — changing its federal funds target rate by altering its purchases and sales of government securities, such as U.S. Treasury bonds. The federal funds target rate set by the Fed influences the federal funds rate, or fed funds rate, which is used by banks to lend money to one another.
Not sure how all this jargon relates to you? Stick with me — I promise it will all become clear.
Tell me more about the federal funds rate
The fed funds rate is the interest rate at which banks lend money to each other on an overnight basis. By law, banks are required to keep a certain level of customers’ funds on reserve. As a result, banks with a surplus will lend to another bank that needs larger balances — often to meet reserve requirements. This back-and-forth lending helps ensure each bank is maintaining proper levels of reserve funds.
The interest rate the lending bank charges another bank for borrowing money is referred to as the federal funds rate. The fed funds rate is not controlled by the Fed but rather influenced by the Fed through the federal funds target rate. We’ll get into this more in a bit.
The TL;DR: The fed funds rate is the main interest rate in the U.S. financial market, and it has a strong influence on other interest rates, such as the prime rate.
Now, what’s this “prime rate?”
The prime rate is the rate at which banks lend money to their most preferred customers — usually large corporations — and it’s one of the most widely used benchmarks in setting types of mortgage, personal loan, auto loan, and credit card rates as well. The prime rate is 8.50% (as of Feb. 8, 2024).
The prime rate itself is based on the fed funds rate, so any time the fed funds rate changes, the prime rate rises or falls, usually by the same amount. Most credit card companies base their interest rates on the prime rate, so when the prime rate changes, the interest rate on, say, your credit card likely will, too — if your credit card uses a variable interest rate, that is.
Why does the Fed raise and lower interest rates?
The short answer is this: to stimulate economic growth and fight inflation. But it’s not that simple. Especially since there’s a lag between the Fed’s actions and the results of them.
The Federal Open Market Committee (FOMC) is the monetary policymaking body of the Federal Reserve, and it meets eight times a year to assess the economy and set the federal funds target rate. So, when the Fed announces rate cuts or hikes, this is to nudge the economy in the right direction. Anytime the Fed announces a change to interest rates, it’s announcing the change of the federal funds target rate. Banks will often follow suit and change the fed funds rate accordingly.
The Fed will raise, lower, or leave the federal funds target rate as is, depending on the economy's health. When the Fed wants to drive the economy forward, it will lower its target rate, and with lower interest rates, borrowing becomes more affordable. Consumers are then likely to spend more. To offset inflation, which tends to follow an increase in spending, the Fed might raise its target rate. This slows the economy, as higher interest rates encourage more saving and less spending.
How does this impact you?
The raising and lowering of interest rates have a direct impact on consumers. While the lowering of rates is good news if you’re working on figuring out how to get a loan or for anyone with credit card debt, it likely means the interest rate on your savings is about to take a hit, too. If rates go up, your savings will benefit, but your debt won’t.
Here are the specifics on how the changing of interest rates affects you:
Your savings account
When the Fed changes its target rate, the fed funds rate follows soon after. And since banks use the fed funds rate to determine the rate they give customers, the interest rate on your savings account will likely soon change as well.
This is especially important for high-yield savings accounts and certificates of deposit (CDs) that offer customers higher interest rates. With a traditional savings account that earns little to no interest, a change in the Fed rate won’t have much impact on your savings. However, if you’re earning 2.5% with a high-yield savings account, you’ll probably notice a 0.25% change.
Regardless, not having your savings in a high-yield savings account means you’re leaving money on the table. So even if rates are cut, you’re still best off keeping your savings in one of these accounts.
Your mortgage rate
For fixed-rate mortgages, a change in the Fed rate shouldn’t have any impact on your monthly payment. The interest rate you agreed to when signing the mortgage is the rate you’ll continue to pay. Additionally, most fixed-rate mortgages are based on long-term rates, such as the 10-year Treasury Note, which tend not to fluctuate as much as short-term rates.
If you have an adjustable-rate mortgage (ARM), however, a shift in the Fed rate will likely mean your mortgage rate will change as well, as ARMs tend to move in step with the fed funds rate. ARMs also have varying adjustment periods, which is when your interest will change. If your interest rate is due to change at the end of the year and the Fed raised the target rate twice in one year, for instance, the increased interest rates can hit you all at once.
Some people also use the Fed’s changing of its target rate as an indication of whether they should buy a home or wait. Consider your situation when determining the right time to take on a mortgage.
Your home equity line of credit
Like an adjustable-rate mortgage, a home equity line of credit (HELOC) is tied to the fed funds rate — more specifically, the prime rate — so a Fed rate change will likely mean your HELOC will also change its rates. Whether you already have a HELOC or are considering one, a Fed rate change could either make a HELOC less or more expensive.
Remember that a HELOC is money borrowed against your home. Even if you can secure a better rate on one due to a change in interest rates, defaulting on this type of loan can still have serious consequences.
Your car loan
A Fed rate change should only affect your existing car loan if it uses a variable interest rate, as that’s tied to the prime rate. However, if you have a fixed-rate car loan, a Fed rate cut could open up the option for you to refinance at a lower rate.
For new- or used-car buyers, auto loans may seem more appealing if the rate is cut. But for most of us, if we absolutely need a car, then we need a car — regardless of which way the rates go.
Your credit cards
The impact a Fed rate change has on credit card debt depends on the type of interest rate the credit card carries — fixed or variable. If you have a fixed-rate credit card, you probably won’t see a change in your credit card interest rate. Variable rates are tied to the prime rate, though. So if you have a card with a variable interest rate, be aware that a Fed rate change will typically result in a change in how much you pay in interest charges.
Your student loan
With a variable-rate private student loan, a change in the Fed rate should translate to paying more or less in interest. A variable-rate student loan, like a HELOC or adjustable-rate mortgage, is tied closely to the prime rate, so a change in the Fed rate will likely mean a shift in your variable-rate student loan.
If you’re on a repayment plan, you might see less money going toward interest and more toward principal if rates are cut, meaning you can pay your loan off quicker. The opposite is true if rates increase.
The bottom line on Federal interest rate changes
Just because the Federal Reserve isn’t always in the limelight doesn’t mean its policies and actions don’t play an important role in the lives of most Americans. The Fed’s decision to change the federal funds target rate — and the resulting cascade of effects — can have both a positive and negative impact on your finances.
A change in the Fed target rate means your existing variable-rate debt will likely fluctuate. If you’re debating opening a new credit card, taking out a loan, or applying for a mortgage, Fed rate changes usually signal potential savings or additional costs. Depending on your priorities and situation, you might be able to take advantage of these adjustments.
As always when it comes to financial decisions, do the math and don’t get caught up in the emotions of the news. Make the decision that’s best for you and your family at the time. It’s all you can ever do.
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