What is the federal funds rate?
The federal funds rate is the interest rate that banks charge one another for borrowing money. The rate then affects consumers because it will also impact the interest rates they pay on loans. This includes car loans, HELOCs and other debt like credit card rates.
Central bank officials announced a 0.50 percentage point rate increase in December, bringing the federal funds rate to a range of 4.25% to 4.50%. This is a big departure from just two years ago.
Back in March 2020, the federal funds rate sat at near zero, and in June 2021 policymakers predicted there would be no rate hikes in 2022.
However, the rate has increased six times since then in an effort to combat inflation.
In the latest statement from the Federal Reserve, policymakers signaled that more hikes can be expected, but potentially at a slower pace.
Who determines the federal funds rate?
The federal funds rate is dictated by Federal Reserve officials, specifically a 12-person comittee — called the Federal Open Market Commitee (FOMC) — that includes the chair of the Reserve, Jerome H. Powell. The FOMC meets eight times a year to discuss the rate, using indicators such as inflation to determine whether a hike is necessary.
The Fed interest rate hike, or funds rate hike, is meant to limit consumer demand. When the rate increases it indirectly affects the interest that consumers pay for loans, such as those used to buy a car or buy a house.
Inflation was at 7.1% as of November 2022, showing a downward trajectory from 7.7% in October. However, this decrease was preceded by a 40-year high in June, when it hit 9.1%. Inflation continues to balloon, because demand remains steady. With the latest hike, the Fed hopes to slow demand and slow inflation even more.
How it impacts borrowing
The federal funds rate helps dictate the prime rate and variable mortgage rates, though not the rates on fixed home loans. Even so, new fixed-rate loans have been getting more and more expensive.
During the earlier stages of the pandemic, the Fed kept fixed mortgage rates in check by buying billions worth of Treasury bonds and mortgage-backed securities every month. Those purchases helped "foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses," the central bank said.
But in May, the Fed announced plans to begin selling off some of those assets.
The federal funds rate more directly affects other forms of borrowing, such as credit cards and car loans.
The interest rate hike also affects the interest you pay for credit card loans. The annual percentage rate (APR) determines how much you pay for any debt that is outstanding at the end of the month. The average APR has increased from 16% prior to this year’s first hike and is now close to 19%.
What does this mean for your credit card payments? Someone with a $15,000 credit card balance will now pay an additional $1,197 in interest (compared to an APR of 16%).
In the first quarter of 2022, the national average rate for a 60-month car loan was 4.07%, but that increased with each rate hike. The average rate sits at 5.27% as of Sept. 14 and is expected to rise even more as result of the rate annoucement.
However, keep in mind that factors such as credit score and your vehicle will affect your given rate.
Home equity lines of credit (HELOCs) are also tied to the federal funds rate, although there is a less direct link. The interest rate for a HELOC is determined by the prime rate, which is usually 3% higher than the federal funds rate. Since HELOC lenders tie their rates to the prime rate, users with a variable rate HELOC will see their interest payments will go up or down based on the federal funds rate.
If the federal funds rate increases, HELOC interest typically increases by the same amount. The average rate for a HELOC now sits at 6.75% (up from 6.51%) for a $30,000 loan. For a 10-year $30,000 HELOC, the average increases to 7.15% (up from 7.08%).
What to do if interest rates go higher
If a mountain of nagging, high-interest debt has you worried, you could roll those debts into a single, lower-interest debt consolidation loan. You’ll pay less in interest, and potentially eliminate your debt sooner and free up some cash flow.
If you're planning to buy a home anytime soon, it's probably time to lock in a mortgage rate, as both adjustable and fixed rate mortgages are getting more expensive with each rate hike. The bigger the purchase, the more your interest rate matters.
Whatever type of home loan you’re shopping for, be sure to compare offers from at least five lenders. Evaluating multiple offers is a proven strategy for finding the best mortgage for your budget.
Before applying for a loan, take a quick, free peek at your credit score. Borrowers with the highest credit scores are typically offered the lowest rates, so you may need to work on improving your score before you approach lenders.
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