With all of the discussion lately in the financial news
you might be wondering exactly what the Federal Funds Rate is and how it
impacts your ability to get a loan or to get a good interest rate on a loan.
Federal Funds Rate Defined
The Federal Funds Rate is the rate of interest which banks charge to each other when
they loan each other money or the rate at which the Federal Reserve will loan banks money
on an overnight basis to help them meet their reserve needs. Currently, the Federal
Funds rate is quoted at 0% to 0.25% according to the most recent adjustment.
This is the lowest rate that banks have ever been allowed to borrow money, and
in reality, this should be a very positive thing to help get the economy moving
in the right direction.
Federal Funds Rate Vs. Prime Rate
The Federal Funds Rate which is 0% to 0.25% and the Prime Rate
which is currently 3.25% are not the same thing. Prime Rate applies to loans that are
typically offered to those who have the best possible credit rating, high account balances
at a bank where they're loaning money and in many cases have little (or no) need to actually
borrow money! Federal Funds Rate is the rate at which Bank A loans money to Bank B or banks
borrow money overnight from the Federal Reserve to meet their immediate cash reserve needs.
How the Federal Reserve Helps
Banks are required by law to maintain certain amounts of money in reserve
based on their assets and liabilities. The Federal Reserve typically
sets this amount at 10% of the banks demand and of course most banks are in the
business of making loans which result in their reserve funds being depleted. In order
to stay within the regulations laid out by the Federal Reserve, the banks borrow money
either from another bank or from the Federal Reserve. This helps keep the bank liquid.
The Impact of Federal Funds Rate Cuts
When the Federal Reserve makes a change in the fed funds rate, it's typically done
during recessions and other times where the economy is in an overall slow period of
growth. If the Federal Reserve makes a determination that says the economy is growing
too quickly then they are likely to raise rates to help slow growth by causing
an environment where the interest rates and payments on money that is owed is higher.
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Higher Interest Rates Make Sense In Some Situations
While it's believed that in some cases these increases can result in forced selling
or defaulting of loans (as seen during this economic crisis we currently find ourselves
in) short term interest rates that are slightly higher can have a positive effect on
gross domestic production and a negative effect on stocks and housing.
See also: Interest Rate Changes,
How The Fed Funds Rate Impacts Your Loan