This morning I received an email from Wealthfront, where I opened a savings account to take advantage of their industry-leading (as far as my research showed) 2.57% interest rate, no fee savings account. The email stated that because of a recent change to the federal funds rate, they APY for my savings account (similar to anyone else who has a Wealthfront cash savings account) would be decreasing to 2.32%. Surely anticipating questions about the change in interest rate from Wealthfront savings account holders, the email contained a link to more information about how the federal funds rate affects savings account rates.

I’m going to explain how the federal funds rate affects savings accounts rates, including everything from high yield online savings accounts to traditional savings accounts opened at local banking institutions.

In case you don’t have time (or interest) to read this entire article, I’ll summarize here. I’ll provide more details further below.

The federal funds rate determines the interest rate that a bank charges another in overnight loans for money needed for the borrowing bank to meet the Fed requirements for money reserves. In order to be profitable, banks must lend their money at a rate that’s higher than what they’re borrowing at. When a bank pays an interest rate on savings accounts is essentially borrowing money from you, the savings account owner.

A lower federal funds rate causes banks to have to lower the rate at which they lend money if they want to stay competitive. Lowering the amount at which they lend money requires them to lower the rate at which they borrow money from other sources (outside of loans from other banks), including your savings account.

Now for a more detailed explanation of how the federal funds rate affects savings account interest rates.

The Federal Funds Rate

The federal funds rate can be a little complicated to explain, as the term is often used to refer to a few different rates. Most often, the federal funds rate is understood to be the interest rate at which banks and credit unions lend their excess reserves to other depository institutions. This funds borrowing and lending exchange happens daily, as these depository institutions comply with mandates by the Federal Reserve to keep a sufficient amount of cash reserves in the course of daily business operations, which regularly include lending money.

Two important distinct rates factor into what is commonly referred to generally as the federal funds rate. One is the federal funds target rate, which is an interest rate number you often hear about in the news when the Federal Open Market Committee meets every couple of months and decides to either raise the target rate, lower that rate, or leave it unchanged. Decisions about what this federal funds target rate should be are made based upon the health of the economy and help to influence how much currency is in circulation throughout the economy.

Another rate associated with the federal funds rate is the federal funds effective rate, which is the weighted average (a statistical representation of the average rates used by banks that places more importance on some loan transactions and lower importance on others) of the loans that occur during a time period.

What Happens When The Federal Funds Rate is Decreased?

When the federal funds rate is decreased, as determined by the Federal Open Market Committee, banks can obviously borrow funds from other banks more cheaply. This is good news for individual borrowers, who can get loans for homes, cars, and other expenses more cheaply than when the rate is higher.

However, for those who have significant money in high-yield cash savings accounts, such as the Wealthfront account I mentioned, a rate decrease results in less earnings for your money.

It is important to note that with most traditional savings accounts, the “extra” interest available because of lower federal funds rates is not passed directly to the savings account owner. Instead, the bank simply keeps it as additional profit. Most people who haven’t discovered the benefits of higher earnings for savings accounts that are available through online banks don’t typically pay attention to changes in the federal funds rate with regard to their savings simply because it doesn’t affect them much, if at all.

Increased Federal Funds Rate = More ROI for Savings

On the other hand, when the federal funds rate is increased, that increase is normally followed by an increase in APY offered to savings account owners. Again, since there is a more direct relationship between the federal funds rate and online high-yield savings accounts (with less overhead involved in high-yield savings accounts, the interest rate more directly affects the account owner), rate increases are more directly passed through to those high-yield savings account owners as more return on the money kept in the account.

Rate Changes Affect Savings Accounts Differently

As I described above, the impact of a federal funds rate change affects different savings accounts differently, although the general trend is that the lower the federal funds rate, the lower the savings account rate. With traditional brick-and-mortar bank savings accounts, a change in rate has much less impact (if any at all) than with savings accounts that are high-yield.