How Lower Fed Funds Rate Affects Banks & Lenders

In times of economic duress, such as has been caused by the coronavirus pandemic, there are a lot of financial variables to keep track of. One of the most significant of these is the Fed funds rate, also known as the Federal Reserve target rate. The impact of this federally set rate reaches far and wide within the U.S. economy, affecting everything from banks to businesses to consumers.

In times of low Fed fund rates, interest rates on loans drop, and options such as VA loans become even more appealing. A VA loan is a mortgage loan partially backed by the Department of Veteran Affairs that requires zero dollars in down payment and can be used to buy a home or refinance one. These loans are limited to veterans and active members of the U.S. military.

What are Fed funds rates? 

The Federal Reserve sets a target rate of interest for lending between banks that is done to meet their reserve requirement. This reserve requirement is an amount of money that the banks have to set aside as a guarantee to ensure their customers’ money and the banks’ solvency. Each bank is required to reserve a certain percentage of its total deposits, as set by the Federal Reserve. To meet this reserve requirement each night, banks borrow from each other and the Federal Reserve fund. The interest rate on these loans made to meet reserve requirements is what’s known as the Fed funds rate, or the Federal Reserve target rate.

As the Feds increase or lower this target rate, the cost of borrowing for banks goes up and down. These increases and decreases in interest rates are often passed, in part, onto the banks’ customers. What this means is that an increased target rate will usually yield increased interest rates on loans that the banks provide to customers. In contrast, a decrease in the target rate will lead to a lowering of interest rates on loans provided to customers.

Why does the Fed change interest rates? 

The Federal Reserve states its mission as “to foster the stability, integrity, and efficiency of the nation’s monetary, financial, and payment systems so as to promote optimal macroeconomic performance.” In less academic jargon, this means safeguarding employment, encouraging price stability, controlling inflation and encouraging financial health within the banking industry. One of the primary tools of the Federal Reserve for achieving this mission is the interest rates charged to banks when they borrow money to meet their reserve requirement.

When the Feds lower the target rate, it frees up the movement of money. Reduced interest on banks often translates to lower interest loans provided to customers, which leads to an increase in loans gained by citizens, which in turn contributes to a rise in spending. Alternatively, when the Feds raise the target rate on banks, the banks often pass this along to customers as increased interest rates on loans. This increased rate restricts the flow of money by reducing the number of people who will seek loans.

In brief, when the Feds raise rates, it becomes more expensive to borrow money and riskier to lend it. When they lower rates, it becomes cheaper to borrow money and less risky. The risk is that high-interest loans are more likely to be defaulted on than low-interest loans.

How do lower Fed funds rates affect lenders? 

While the Feds set the rate at which banks can borrow money to meet their reserve requirement, the interest rates that get charged to customers is up to the lender and not the Federal Reserve. The fluctuation of Fed fund rates is a tricky formula for lenders. As the Federal Reserve target rate increases, lenders charge a higher interest rate on loans that they provide, but they see a decrease in eligible loan applicants. When the Federal Reserve target rate decreases, banks charge less interest per loan but see an increase in eligible loan applications. Ideally, from the lenders’ perspective, they should be able to adjust their interest rates on loans provided to maintain a consistent level of profit. However, it doesn’t always work out so concisely.

Whether higher or lower interest rates are best for lenders is a matter of some debate. Still, experts tend to believe that long-term lender profits are “largely unrelated to the general level of market interest rates.” Provided that lenders can obtain an increase in business in tandem with lowered market interest rates, the reduced rates do not noticeably impact their profits. For example, one loan at four percent and two loans at two percent, on the same amount of money will yield the same amount of interest.

How do lower Fed’s funds rates affect banks? 

When the Feds lower the fund rate, the impact can spread widely. Banks pay less on their loans taken out to meet the reserve requirement, which leads to them reducing the interest rates on loans they provide to customers. However, the interest rates on high-yield savings accounts also take a dip. In general, the lower fed fund rate causes a ripple effect wherein interest rates throughout the market are lower. While this can make borrowing money easier and cheaper, it does mean that investments earn less per dollar. From savings accounts to certificates of deposit, a lower Fed fund rate can reduce earnings.

While it may be intuitive to think that banks are better off with higher interest rates, the truth is more complicated. Higher interest rates usually reflect a higher Fed fund rate, which makes it more expensive for the banks to meet their reserve requirement, even though the banks earn more on the loans that they provide customers. With lower rates, it becomes cheaper for the banks to meet their reserve requirement, but they charge less interest on the loans that they provide to customers. At a macro scale, banks’ profit margins are not directly impacted by fluctuations in the Fed’s fund rates. Instead, the number and size of loans that these banks provide are what tend to fluctuate in tandem with the Fed’s fund rate. By scaling this element of their business, the banks can perform a balancing act that maintains profit margins. As a result, the best interest rate for the well-being of banks is somewhere in the middle—not too high and not too low.

Joshua Cox-Steib

Personal Finance Contributor

Joshua Cox-Steib is a personal finance contributor. He lives in Tulsa, OK, with his wife and their three pets. He spends his spare time reading, writing, and gardening. Find out more on Joshua Cox-Steib at www.jcswriting.com.