What is the Federal Funds Rate and how does it affect the interest rate you'll be offered if you want to buy a home or refinance your mortgage? The answer may surprise you.
What the Fed Funds Rate is
The Federal Funds Rate is the interest rate that banks—called “depository institutions”—charge one another for loans of their reserve funds. In other words, it’s a rate that one bank would charge another bank for an interbank loan. These loans usually are made because one bank has excess funds to lend and another bank has a temporary shortfall of funds. Typically, the funds are loaned out just overnight and then paid back the next day.
The Federal Funds Rate is so named because the banks’ reserves are kept on account at the Federal Reserve. It is also commonly referred to as the “Fed Funds Rate” or even just the “Funds Rate.” The Fed periodically sets a target rate for the Federal Funds Rate, but in practice banks can vary the rates they charge one another from day to day.
The Federal Reserve’s target for the Fed Funds Rate is part of the Fed’s mandate to promote maximum employment, stable prices and moderate long-term interest rates. A lower Fed Funds Rate can stimulate economic expansion while a higher Funds Rate can curb economic growth if prices start to go up. The Fed first began to announce its targets for the Federal Funds Rate in 1995.
How the Federal Funds Rate affects mortgages
When people say the Fed “raised interest rates” or “lowered interest rates,” they usually mean the Fed raised or lowered the Federal Funds Rate.
Changes in the Federal Funds Rate can indirectly affect other short-term interest rates, foreign currency exchange rates, long-term interest rates and the money supply, according to the Federal Reserve’s website. That means the rate can indirectly affect the rates borrowers pay on mortgages and other types of loans.
The Federal Reserve doesn’t directly set interest rates on mortgages or other types of loans, even though short-term interest rates do tend to rise and fall when the Federal Reserve raises or lowers its target for the Federal Funds Rate. If the Fed raises its target for the Funds Rate, other short-term rates will tend to go up, and if the Fed lowers its target for the Funds Rate, other short-term rates will tend to go down.
The Federal Funds Rate may have an indirect effect on mortgage rates, although this effect is generally more tenuous than the effect it has on shorter term rates.