Federal Interest Rate: An Overview
We all know that barrowing money, costs money, but how does this get determined for the little guy?
The first and most basic interest rate is the Federal Funds Rate, sometimes called the overnight rate. It’s determined by looking at the interest rate that various financial institutions are charging each other on the average at any given time. This is also referred to as the Federal Funds Effective rate.
The reason banks have to barrow so much from each other is that they are required by federal law to have a certain amount of cash in reserve to back up their transactions and accounts. Some banks have more than they need to have which puts them in a position to make fairly certain money by loaning to other banks that need to keep their cash reserves at the right levels. Sometimes banks want to finance something bug but if they did so they would not have the right amount of cash still in the coffers to satisfy the fed.
Then there are committees like the Federal Open Market Committee an arm of the Federal Reserve that makes decision about how much money should cost to borrow, and can actually change the interest rate by buying its own money off the market which lowers supply thereby increasing cost by way of an interest rate increase.
When the economy looks like it’s slowing down they want to lower the price of cash to help it move. Like an item at a store going on sale to make sure it gets purchased. This is the market at work and a ton of supposedly really smart people dedicate a lot of time tracking it and trying to figure it all out.
If you’re worried about really understanding all this, don’t, there’s not much the little guy can do to effect these decisions unless he or she can change the entire financial outlook of the country.
What is important to understand is that a lot of other rates are based on this basic federal rate.
If a bank has to pay 3% to borrow money in order to be able to loan it to you, they will also need make a profit, so they mark up the cost of borrow to 6% and if you can prove that you can pay the money back plus this profit you get your home loan, your car loan, school loan, or business loan.