How are interest rates set?

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Andrew Goldman

Andrew Goldman has been writing for over 20 years and investing for the past 10 years. He currently writes about personal finance and investing for Wealthsimple. Andrew's past work has been published in The New York Times Magazine, Bloomberg Businessweek, New York Magazine and Wired. Television appearances include NBC's Today show as well as Fox News. Andrew holds a Bachelor of Arts (English) from the University of Texas. He and his wife Robin live in Westport, Connecticut with their two boys and a Bedlington terrier. In his spare time, he hosts “The Originals" podcast.

Interest rate is a term that you’ll come across a lot, but it’s oddly nonspecific — though there is a whole ecosystem of various kinds of interest rates that are all interconnected. When you hear that the Federal Reserve has raised or lowered interest rates, that specifically means that the twelve members of the Federal Open Market Committeehave convened, as they do every six weeks, and decided that they’re going to adjust America’s benchmark interest rate, called the Federal Funds Target Rate. This rate dictates the interest that banks will charge one another to lend their surplus cash reserves so that all banks have the federally-mandated amount of funds on hand at all times. (Interestingly, the cash doesn’t literally move — apart from a small portion kept in banks’ vault, most of it stays safely deposited within a Federal Reserve bank.)

The Fed will keep the rate unchanged if all within the economy is operating smoothly. They’ll lower it to get more money circulating through the economy in the form of lower-interest loans. They might even raise it if money is becoming too readily available, a condition that will lead to inflation. The raising or lowering of the Federal Funds Target Rate won’t directly affect you — your variable interest rate credit card or mortgage won’t immediately change, for instance. But it will certainly indirectly affect you, since any change by the Fed will precipitate a corresponding rise or fall of the U.S. Prime rate an unofficial credit rate that American banks offer to their most creditworthy clients. The U.S. Prime rate, traditionally computed as the Federal Funds Rate plus 3%, is the number that will directly affect consumer mortgage rates, small business loans, credit card APRs, and any other purpose you could think of that banks might loan you money.

Last Updated March 6, 2018

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