Whether you’re buying a home for the first time or a longtime homeowner thinking about refinancing, mortgage rates should be a top concern. Making sure you have the lowest rate possible on your mortgage is key to saving potentially thousands of dollars over the life of your loan.

One important factor that affects mortgage rates is the federal funds rate. To better understand how and why interest rates fluctuate — plus, how to get a good rate on your home loan — it’s important to learn the definition of the federal funds rate and what it means for mortgages.

Key Takeaways:

  • The federal funds rate is the average interest rate that banks charge each other for overnight loans.
  • The Federal Reserve sets a target for this rate, and will influence it through the buying or selling of securities that affect how much cash banks have available for overnight loans.
  • Interest rates for mortgages and other types of loans are influenced by the federal funds rate and the actions that the Fed takes to achieve its target.

What Is the Federal Funds Rate?

The federal funds rate is the interest rate banks charge each other for loans overnight. When banks have excess cash on hand, they lend it to other banks that need to boost their balances. The weighted average interest rate of all the loan negotiations between these banks is known as the effective federal funds rate.

The policymaking panel of the Federal Reserve, the country’s central bank, sets a target range for the federal funds rate. This panel, called the Federal Open Market Committee, influences the federal funds rate through open market operations.

The federal funds rate is important because it’s the central interest rate for the U.S. financial market. It directly affects the rates that banks pay and earn on overnight lending, which means it has an indirect effect on longer-term rates, such as the interest rates on mortgages, other loans, and savings accounts.

Knowing how the federal funds rate works could help first-time homebuyers or homeowners understand how much a mortgage or refinance will cost them.

Who sets the federal funds rate?

The FOMC is responsible for determining the target federal funds rate. The 12-member committee comprises the seven members of the board of governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York, and four rotating members drawn from the remaining 11 Reserve Bank presidents.

How does the Fed set interest rates?

The FOMC meets eight times per year to consider changes to the target federal funds rate.

“The Fed has two main objectives for the economy: a strong labor market and stable prices,” says Nicholas LaClair, a pricing analyst and lock desk manager at Embrace Home Loans in Middletown, Rhode Island.

If those objectives aren’t being met, the FOMC may adjust the target federal funds rate higher or lower. The Fed typically aligns the effective federal funds rate with the target rate through open market operations. This involves buying or selling securities — specifically government bonds.

How Does the Federal Funds Rate Work?

Whether the FOMC wants to increase or decrease the federal funds rate determines what steps the Fed will take to influence it.

“If the Fed wants to lower the federal funds rate, they will buy securities from banks, which will increase reserves and the money available to lend out,” LaClair says. With more money to lend, banks can charge lower interest rates.

On the other hand, if the Fed wants to increase the federal funds rate, it will sell securities. That reduces reserves and the amount of money that banks can lend.

“With less money available to lend out, banks will charge a higher rate,” LaClair says.

The Fed’s long-term goals will determine the direction in which the Fed tries to move the rate.

When the federal funds rate goes up

The FOMC typically aims to raise the federal funds rate when the economy is strong and at risk of overheating. Raising the federal funds rate makes it more expensive to borrow money, and encourages individuals and businesses to save more rather than spend. This can slow down the economy somewhat, which can help prevent it from expanding too rapidly and ending up with high levels of inflation.

Traditionally, the Fed has targeted a long-term inflation rate of 2% per year.

“A higher federal funds rate makes borrowing money more expensive, which causes a cooling effect on the economy to slow down growth,” says Richard Steinberg, chairman of Nationwide Mortgage Bankers in Melville, New York.

Those higher costs mean borrowers and lenders must be more selective when it comes to where they spend money.

Raising the federal funds rate also gives the FOMC more room to work with if the economy enters a downturn.

When the federal funds rate goes down

Lowering the federal funds rate is one way for the FOMC to try to help the economy by encouraging borrowing and spending. If the economy starts to slow down or enters a recession, encouraging spending can help it return to growth and prevent deflation.

For example, during the 2008 recession, the FOMC cut rates from 5.25% to near 0% to try to ease the recession and kick-start the economy back into growth.

“A low federal funds rate makes borrowing money less expensive and causes markets to heat up through broader investments, particularly in housing,” Steinberg says.

The Federal Funds Rate Today

The FOMC has consistently raised its target federal funds rate over the past year and a half. As of mid-October 2023, it sits at 5.25% to 5.5% — well above its target range of 0% to 0.25% throughout 2021.

Persistent inflation as the economy recovered from the COVID-19 pandemic, as well as effects from the Russia-Ukraine war, have been the main reasons the Fed has raised rates. Though inflation has eased from a peak of 7% down to 3.3% in late August 2023, it is still well above the Fed’s target, and many expect rates to increase further as the FOMC attempts to curb inflation.


How the Federal Funds Rate Affects Mortgage Rates

The federal funds rate doesn’t directly influence interest rates for other things, such as savings accounts or mortgages. Instead, it creates a ripple effect that causes the rates on other things to adjust.

The federal funds rate is the amount that a bank can earn or must pay for overnight lending with other banks. Banks that have an excess of funds have little reason to lend money to consumers for less than the federal funds rate because they can get an almost risk-free return from that money by lending it overnight.

On the other hand, banks that borrow from other banks have to charge more than the federal funds rate to turn a profit. So, rates for other loans — like mortgages — increase.

The impact of the federal funds rate is seen immediately in short-term securities, Treasury bills, and money market accounts. Eventually, the ripple effect makes its way to the interest rates tied to mortgages, home equity lines of credit, credit cards, and auto loans.

When it’s cheaper for banks to conduct business, they can pass along the savings to borrowers via lower interest rates. So, if the federal funds rate is low, mortgage rates are also typically low.

Keep in mind that fluctuations in the federal funds rate won’t have an impact on your loan if you already have a fixed-rate mortgage, since your interest rate is set for the entire loan term. But if you have an adjustable-rate mortgage, your interest rate could change after the federal funds rate goes up or down.

Tips To Get a Good Mortgage Rate

Now that you have Fed interest rates explained, how do you qualify for the lowest mortgage rates? Here are some steps you could take to increase your odds of getting a mortgage with a low rate:

  • Save up a large down payment. Though it’s possible to put as little as 3% down, saving for a bigger down payment could help you secure a lower interest rate. By doing so, you would also face a smaller monthly payment and lower overall costs.
  • Improve your credit. Buying a house with no credit or poor credit can be difficult. So, if your credit score isn’t in great shape, spend some time improving it before applying for a mortgage. LaClair recommended aiming for a score of at least 740.
  • Consider paying discount points. By choosing to pay points, you increase your closing costs in exchange for a lower interest rate on the loan. Though you pay more upfront, you end up paying less mortgage interest over time.

The Bottom Line on the Federal Funds Rate

The federal funds rate is an important tool used by the Fed to keep the economy healthy. Changes to the Fed’s target rate trickle down to consumers and the interest rates they receive on everything from savings accounts to mortgages. While you can’t control the federal funds rate, there are other things you could do to get a good interest rate on your loan.

T.J. Porter contributed to the reporting of this article.