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Personal Finance

Understanding the federal funds rate: What it is and how it affects your wallet

The federal funds rate is perhaps the most influential interest rate in the U.S.

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The fed funds rate (also known as the federal funds target rate) is the interest rate at which commercial banks lend to each other overnight. Below, CNBC Select explains how and why the Federal Reserve sets this rate, and how it affects the economy, as well as your own money.

How does the Federal Reserve control the federal funds rate?

Laws and regulations require banks to keep a minimum amount of money in reserves (to help guarantee that depositors can always withdraw their funds from the bank). Because banks don't earn any interest on this money, they generally try to maintain the smallest amount of reserves possible (without violating the law). One of the ways banks with excess reserves get rid of that money is by lending it to other banks that have less than the legally-mandated amount in their reserves.

Similar to when the bank gives you a mortgage or auto loan, a bank will charge another bank an interest rate on these loans. That interest rate is determined by the Federal Reserve when a 12-member committee meets several times a year to set a target interest rate known as the federal funds rate. The Fed will adjust the rate to make borrowing between banks more (or less) expensive to help fulfill their mission of promoting a healthy economy for the country.

How does the federal funds rate affect interest rates for consumers?

The interest rate banks charge each other informs the rates they charge their customers for products. When the Fed raises the target rate, banks increase their rates too, making credit more expensive and savings accounts more lucrative. Lowered rates, on the other hand, have the opposite effect.

Currently, we can see the former playing out. After multiple interest rate hikes, interest rates on credit cards and loans have made borrowing expensive. The impact reverberated throughout the economy. Rising mortgage rates have priced out many hopeful homebuyers and rates on auto loans have made car shopping a challenge.

On the bright side, it's an excellent time to save as you can find interest rates on high-yield savings accounts north of 4% and even 5%. For example, the Western Alliance Bank High-Yield Savings Account, CNBC Select's choice for earning a high APY, offers 5.24% APY. And our top pick for the best high-yield savings account, the LendingClub High-Yield Savings, offers an APY of 5.00%.

Western Alliance Bank High-Yield Savings Account

Western Alliance Bank is a Member FDIC.
  • Annual Percentage Yield (APY)

    5.24% APY

  • Minimum balance

    $1 minimum deposit

  • Monthly fee

    None

  • Maximum transactions

    Up to 6 transactions each month

  • Excessive transactions fee

    The bank may charge fees for non-sufficient funds

  • Overdraft fee

    No overdraft fee

  • Offer checking account?

    No

  • Offer ATM card?

    No

Terms apply.

LendingClub High-Yield Savings

LendingClub Bank, N.A., Member FDIC
  • Annual Percentage Yield (APY)

    5.00%

  • Minimum balance

    No minimum balance requirement after $100.00 to open the account

  • Monthly fee

    None

  • Maximum transactions

    None

  • Excessive transactions fee

    None

  • Overdraft fees

    N/A

  • Offer checking account?

    Yes

  • Offer ATM card?

    Yes

Terms apply.

Such high rates on credit and savings won't last forever. If the Federal Reserve is successful in bringing inflation down, it might decide to begin lowering the federal funds rate at some point — and interest rates on consumer products will follow.

How does the federal funds rate affect inflation?

By raising the federal funds rate, the Federal Reserve aims to cool down inflation. In the ideal scenario, higher borrowing costs discourage consumers from spending money. This should prompt sellers to lower prices to retain customers. As a result, overall inflation subsides and the economy slows down.

However, slowing economic activity can lead to rising unemployment and even a recession. When that happens, the Federal Reserve needs to give the economy a boost, so it may opt to lower its target rate. This way, consumers can take advantage of lower interest rates on credit products, which gives them more spending power. People begin to use more of their budget to pay for goods and services, driving economic activity. At the same time, increased demand can lead to higher prices and more inflation.

Watching the Federal Reserve manage this balancing act with the economy might make you feel powerless, but paying attention to the federal funds rate can help you make smart financial decisions. Interest rate hikes, for example, mean you should prioritize getting rid of credit card debt and saving. When rates are low, you might think about financing a large purchase. That said, what the Fed is doing (and how it affects the economy) is just one factor you should consider when making financial decisions. Don't base your entire budget on it.

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Bottom line

The federal funds rate is arguably one of the most important interest rates in the world. It influences inflation and the economy in the U.S. — and your money. Tracking the Fed's decisions allows you to set expectations about what will happen to interest rates on savings and credit products and plan accordingly.

Catch up on CNBC Select's in-depth coverage of credit cardsbanking and money, and follow us on TikTokFacebookInstagram and Twitter to stay up to date.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.
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