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What Are Federal Interest Rates?

We can pretty safely bet that you didn’t wake up this morning thinking, “What are federal interest rates?”

No one wakes up, makes their morning cup of coffee, and meditates on how banks and inflation work.

Unless you’re one of those Federal Reserve Board guys, I guess.

But, if you plan on having a financial future you’re in complete control of, it’s good to know how and why these government systems rule our lives (whether we like it or not) and how to use them to our advantage.

Knowledge is power, girlfriend, and we’re gonna knowledge it up together.

What are federal interest rates? Who’s responsible for them? 

The complicated definition is that the federal funds rate is “the target interest rate set by the Federal Open Market Committee (FOMC) at which commercial banks borrow and lend their excess reserves to each other overnight.”

But that means nothing to me, so let’s break it down.

Basically, banks are required to have a certain amount of money in reserve at the end of every day. It’s the law.

So, if they think they’re going to fall short of that, they can borrow money from other banks with interest set at the federal funds rate. 

If a certain bank happens to be killing it and is going to have more than the required amount in reserve, they can lend that excess to other banks and rake in the interest.

Overall, this system ensures that all banks keep a certain percentage of their customer’s money on reserve.

But they don’t earn interest on this reserve money, so they try to stay as close to the limit as possible without going under it.

So, long story short, the federal funds rate is the interest rate the banks are hit with when they borrow from each other.

Federal interest rates are determined by The Federal Open Market Committee (FOMC), which is a branch of the Federal Reserve System.

In other words, there are some dudes in the government arbitrarily controlling a bunch of stuff that makes your life harder.

Classic.

Great. Why Do I Care?

Raising the rate makes it more expensive to borrow money and — you can probably guess this next part —  lowering the rate makes it less expensive to borrow money. 

The idea is that when you cut rates, borrowing becomes cheaper and allows businesses and individuals to more easily take out loans, take out lines of credit, and buy stuff. 

So, when rates are low, people are more likely to borrow (and need) money and this boosts the economy when it’s in a slump.

You know, because it’s always a good idea to tell people who are already worried about money to rack up some debt. ?

Alternatively, when business is booming, interest rates become higher because the economy is already doing well.

Because that’s just how life works — when you’re doing well, you’re gonna pay for it.

The federal interest rate affects all of our financial concerns — loans, life insurance, mortgages, the stock market.

The higher the federal funds rate, the higher the interest you pay on all of these things. 

In fact, there’s almost no facet of society that the federal funds rate doesn’t touch

Stocks and bonds?

Yep. Lower interest rates cause corporate bonds to fall, making them less attractive to new investors.  

The housing market?

Absolutely. Rate hikes can make it impossible to close on a good fixed loan rate on a new home. 

Personal borrowing?

You betcha. The federal interest rate determines how high your interest rates will be when you apply for a credit card, student loan, or need to borrow money. 

And, most importantly, it works in conjunction with inflation, which is when stuff gets really expensive.

Inflation occurs when a nation’s currency is losing value or when the economy is growing so quickly that the demand for goods is greater than the supply, which drives up prices.

When inflation rises, interest rates are often increased as well, so that banks can keep inflation in check and vice versa.

So, as you can see, there’s no way to avoid it — the federal interest rate is totally in your life.

I’m Still Not Sure Why I Care

Well, it’s just good to know. The inner workings of our complicated system are absolutely going to impact your major financial decisions.

So, it’s good to be aware of how they work so you can make smart choices at the right time.

The more you know, the more control (and #GIRLPOWER) you have.

And, just in case you wake up tomorrow and think, “I just HAVE to know what federal interest rates are,” well, now you know.

You’re welcome.

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