What the Federal Funds Rate Means for the Average American Citizen

With the recent announcement by the Federal Reserve that they are lowering interest rates, a lot of information has arisen as to what effect will the lowering have on the economy. On a more personal level, people are asking how it is going to affect them, not just the country as a whole. Unfortunately, too many people don't quite understand how the economy runs and how the Federal Reserve's Interest Rate affects them. In this article, we are going to try to answer some of the basic questions regarding the Federal Funds Rate and how it affects you personally.

First off, what is the Federal Funds Rate? Simply put, it is the interest rate that banks charge each other for loans overnight. Of course, the question arises as to why banks need to borrow money from each other. The reason for this is that sometimes banks run low on their cash reserves. For every dollar that someone has deposited in a bank account, that bank must have at least 10% of that amount in cash on hand. The bank is free to use the other 90% to loan out to other people. That is how banks make money; they give you maybe 4-5% on a savings account, and then charge people 10-12% on a car loan. Basically, by using your money, they are making a pretty good profit. However, sometimes they are short of that 10%, so they need to borrow money from another bank. The Federal Funds Rate was set up so there would be a standard as to what banks could charge each other during that time.

So, what does that mean for you as a consumer? Well, the Federal Funds Rate essentially determines what percentage you are going to be charged when you use things such as Credit Cards. The Federal Funds Rate affects what is known as the 'Prime Rate.' The Prime Rate, according to Moneycafe.com, is the rate at which banks charge their best customers. While this rate is always higher than the Federal Funds rate, they are related because when the reserve lowers the money that it charges banks, they can in turn lower the Prime rate and still make money.

The prime rate is essentially what guides banks in their lending practices for everything. It regulates home loans, car loans and credit cards. Basically, the banks set a Prime Rate based upon several things, but the Federal Funds Rate is a major part of it. That rate then is the guidelines for what percentage you are given on a loan or a credit card based upon your credit score (which serves a much greater importance, but is too long to discuss in this article).

So, is the recent decrease in the Federal Funds Rate going to help the economy? The answer is maybe. The problem with economics and federal policy is that there are so many variables. The best way to describe the U.S. economy and the government's affect on it is to look at the game Mouse Trap©. All of us who have played the game know that you turn the dial and it is suppose to go through all this elaborate steps to finally knock down a trap that gets the mouse. However, what always happens is the ball stops, or something doesn't work, so you have to push it along. This is the U.S. economy. The steps that the government takes are only the beginning. There are so many things that can go wrong, or go well, that it is hard to determine what effect it will have on our economy.

However, there is good news. With the lowering of the federal rates, you will see a decrease eventually in your interest rates. First off, if you have a variable mortgage, once the banks lower their Prime Rates (which are usually at the beginning of each month) your mortgage will decrease. Also, if you carry a credit card where the interest rate is based upon the prime (whether it is directly based on prime or prime plus) once they decrease it, your credit card rates will decrease.

So, overall, the Federal Funds Rate can seem a little much at times. However, the key thing to remember is this: the lower the Federal Funds Rate, the lower the Prime Rate and therefore the lower your payments on things such as Credit Cards and Home loans. However, do not assume that we should always have it really low, that is where inflation comes to play. However, inflation is another topic for another day. What is key is to remember, if there is too much money in the economy, inflation will happen. When the Federal Reserve lowers its' rates, there is a chance of inflation increasing.

The most important aspect of all of this is to research this information. If you want to get a good feel for how the economy works, you need to research it and if you are lucky enough to take college classes, take an economics course or two. That is the best way to understand what is happening when you hear things in the news regarding the economy.