The Federal Open Market Committee (FOMC) – a bunch of smarty-pants from the Federal Reserve Board and Federal Reserve Bank – meet eight times a year to talk about money issues, one of them being the federal, or “fed,” funds rate.
The fed funds rate is the rate at which banks lend money to one another and may affect the interest rates on your credit cards, savings and short-term loans like adjustable rate mortgages (ARMs).
Here’s how it works:
If you have a credit card, chances are it’s tied to the prime rate. Prime is simply three percentage points greater than the fed funds rate. So, for example, if the fed funds rate is 1%, then prime rate is 4% (1% + 3% = 4%). A lower fed funds rate means a lower prime rate and a happier credit card holder.
The fed funds rate also affects short-term interest rates such as those on adjustable rate mortgages. As is the case with your credit cards, a lower fed funds rate means lower short-term rates and happier homeowners.
So we’re always crossing our fingers for a lower fed funds rate, right? Not quite. The fed funds rate also affects the interest rates on savings accounts, money market accounts and CDs. The lower the fed funds rate, the lower the savings rate, which makes for an unhappy saver since you’re making less on your money.
It’s a common misconception that the fed funds rate directly affects long-term interest rates, like what you might pay on a 30-year fixed rate mortgage. Long-term interest rates are actually determined by the people who buy and sell bonds in the bond market everyday. And bond yields are affected by the health of the economy and inflation. So while the fed funds rate may indirectly impact long-term interest rates, it’s not a as strong of a relationship as some might think.
In sum, when the fed funds rate is low, that’s good news for your credit cards and short-term loans, but bad news for your savings.