Today I want to talk about interest rates and how they impact your everyday life.

Many of you have probably seen the news talking about increasing interest rates, decreasing interest rates, or holding rates steady everywhere you look.

But what does that mean?

Let me explain:

When the Federal Reserve, aka "The Fed," talks about interest rates, they're referring to the Federal Funds Rate.

The federal funds rate is the target interest rate banks charge other banks to borrow money overnight. This is a target range, not a specific rate. For example, the current federal funds target rate is 5.25% to 5.50%.

Banks borrow money to meet reserve requirements. These reserve requirements ensure banks have enough cash on hand to help guarantee stability and solvency and prevent bank runs.

It’s also one of the three main tools the Federal Reserve uses for conducting monetary policy (but that’s for a different newsletter).

So how does the federal funds rate affect you?

Well, the federal funds rate directly impacts the Prime Rate.

The prime rate is the rate banks charge their most creditworthy customers for loans.

Think 800+ FICO scores.

Prime sets the baseline for a variety of bank products for businesses and consumers:

• auto loans

• mortgages

• credit cards

• personal loans

• business loans

When Prime goes up, so does the cost of accessing these products.

Of course, the prime rate moves only when the federal funds rate moves.

And those who can't or don't want to pay the higher borrowing cost will postpone purchases involving financing.

Consumers will likely opt to save money and earn higher interest payments through certificates of deposit (CDs) or high-yield savings accounts (HYSAs).

In theory, increasing interest rates will:

• reduce the supply of money in circulation

• slow economic activity

• lower inflation

Conversely, decreasing rates would:

• increase the supply of money

• stimulate the economy

• increase inflation

The rule of thumb is the prime rate is the federal funds rate plus 3%.

So if the federal funds target range is 5.25% to 5.50%, that would make prime 8.25% to 8.50% (5.25% + 3% = 8.25%) or (5.50% + 3% = 8.50%).

The current prime rate is in the Wall Street Journal Money Rates table.

Closing Thoughts

The Fed holds eight regularly scheduled meetings per year. At those meetings, the committee discusses rates.

Now, the next time you hear something about interest rates, you’ll understand what it means and how it impacts you.

Darrell