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Federal Reserve officials raised the federal funds rate on Wednesday for the third time this year. The rate increased by a notable three-quarters of a percentage point, the largest increase since 1994.
This increase, like previous increases, is likely to have an effect. Higher interest rates can raise costs for borrowers, but it can also mean higher yields for savers. After all, when you have a savings account at a bank, you’re effectively letting the bank borrow your money, and the institution pays you interest in return.
A Fed rate increase doesn’t instantly change the rates your bank offers, but it can lead to an increase for some accounts. In a higher rate environment, banks may start raising rates on savings accounts to attract new customers. This puts competitive pressure on other institutions to increase their rates. If one bank starts, others are likely to follow.
What is the federal funds rate?
The federal funds rate, or the “Fed rate,” is the interest rate that banks charge each other to borrow money overnight. According to the Federal Reserve, institutions borrow money and lend from their reserves after hours in order to meet regulatory requirements and to be ready to manage market conditions.
The funds rate is set by the Federal Reserve, and the Fed uses it to help adjust monetary policy based on economic conditions. It affects you as a consumer in various ways. For example, raising rates can help ease inflation: A higher interest rate generally leads to higher costs for a loan or credit cards, so households may be less willing to borrow money. That could lead to less spending, which could result in lower prices and less inflation.
Take advantage by choosing a high-yield account
Any time there’s a Fed rate increase, it’s a good idea to check the interest rate on your savings accounts and shop around for a better option. Not every bank will follow others in lifting its rates. Some consistently offer a low annual percentage yield of around 0.01%, and the current national average savings account rate is only 0.08% APY, according to the Federal Deposit Insurance Corp .
But online savings accounts tend to offer better rates — many times higher than that average — because institutions that offer these accounts don't have to operate expensive branches and can pass the savings on to customers in the form of higher rates and low (or no) fees.
A higher APY can make a visible contribution to your bank balance. Say you have $10,000 in a savings account that earns a low 0.01% APY, which is typical for large banks. After a year, that balance would earn only about a dollar in interest. But put that amount in a high-yield savings account that earns a 0.50% APY, and it would earn about $50 after a year. That interest would also earn interest over time, a feature known as compound interest. High-yield savings accounts may not make you rich, but you’ll automatically earn much more than you would with a lower rate option.
Use a savings calculator to determine what your bank balance can be with different APYs and see how your money could grow.
With low rates, why put money in any savings account?
Inflation erodes spending power, since it means goods and services are more expensive than they were previously. So when the inflation rate is significantly higher than the average national savings account rate — as it has been since late last year — it may seem that parking money in a savings account isn’t beneficial.
But the larger reason for saving cash is to have easy access to money in case you need it quickly, say, for an unexpected car repair expense. Setting aside funds for financial emergencies can help prevent you from going into debt, which can be costly, especially when interest rates rise.
Having at least three to six months’ worth of expenses tucked away in an emergency savings fund is ideal, but anything you can put away would help. And having that money earn interest is a bonus way to have your dollars work for you.
If you have a fully funded emergency savings account, and you have extra cash that you don’t need to access right away, it may be worth looking at other short-term options to grow your money. Some inflation-matching savings bonds, for example, can earn a better yield than even the best savings rates. But you will need to leave the money parked in the account for a predetermined time period — a year or more, for example. (Learn more about these bonds and other ways to protect your spending power in this article). For longer-term goals, such as retirement, it makes sense to look into investing.
The Fed funds rate is worth paying attention to. With increasing rates, loans are generally more costly, but savings accounts can earn higher yields. For those who have little or no debt and can contribute to savings, a Fed rate increase could be a financial opportunity.