Personal loans are a popular and easy way to pay for larger expenses such as moving, home improvements, weddings and even emergencies. They’re also handy for consolidating your high-interest debt, such as from credit cards, to a lower rate that’ll help you save money over time.

How much you pay for personal loans depends on several different factors, including your credit score and history, income and the federal funds rate.

What Is the Federal Funds Interest Rate?

The federal funds rate is the target rate that the Federal Reserve sets for banks to lend to each other overnight. Banks lend to each other every night because they need to keep a certain amount of money at the bank and available for people to withdraw the next day, also known as reserves.

Each day, some banks might have more or less than they need for their reserves, depending on how people deposited or withdrew money during the day. By lending money to each other overnight—at the target interest rate set by the Federal Reserve—they can ensure that they meet their reserve requirements.

The federal funds rate is the first tipping point in a long line of dominoes that ripple out and impact the entire economy—including you—in other ways. For example, because the federal funds rate helps determine the cost for banks to exchange money, banks pass that onto you when you need a loan. The higher the federal funds rate, the more they charge you for a personal loan, and vice versa.

How Is the Federal Funds Rate Determined?

The federal funds rate is set by the Federal Open Market Committee (FOMC), a group of 12 high-ranking members of the Federal Reserve system. They change the federal funds rate in an attempt to move the economy in certain directions. For example, if inflation is higher than they’d like, they may raise the federal funds rate to try and curb inflation.

One point that’s often confusing is that the FOMC sets a range of rates, which are more like targets. Banks are free to choose whatever rate they want to lend to each other within that range. The rate that banks actually do lend money to each other at is called the effective federal funds rate.

How the Federal Funds Rate Affects Personal Loan Rates

While the federal funds rate is a bit of an obscure money policy, it does impact you. That’s because of how it plays a role in your overall personal loan costs, among other lending products.

Each personal loan lender sets its own range of interest rates that it might charge. The lowest interest rates are typically reserved for highly-qualified applicants while higher rates generally fall in the laps of people with lower or damaged credit.

Most lenders base their interest rates off of some index, such as the prime rate. For example, they may set their lowest rate at the prime rate plus 3%. If the prime rate is 3.25%, then that means you’d be charged 6.25%.

These indexes are themselves based partially on the federal funds rate. As the federal funds rate goes up, so do the indexes, which then causes personal loan interest rates to increase, too.

Fluctuations in the federal funds rate are like a cascade of dominoes that ultimately come back to you—the borrower.

Interest Rates Impact on the Cost of Borrowing

Interest rates play a key role in personal loans because they determine how much it costs you to borrow the money and how much you owe monthly.

Take, for example, SoFi, which offers personal loan rates starting around 5% annual percentage rate (APR). Here’s how much it would cost to take out a $5,000, four-year term loan at three different rates:

Federal Funds Rate 2022 Forecast

The effective federal funds rate has been about as low as you can go since April 2020, hovering around 0.08%. The latest minutes from the FOMC meeting in December indicate they will increase rates, and at a faster pace this year.

According to the Federal Reserve, the median of where FOMC members and Federal Reserve bank presidents believe the rates will go moving forward is 0.9% in 2022, 1.6% in 2023 and 2.1% in 2024.

Another question is about when those rate hikes will occur. The FOMC meets eight times in 2022, and they could raise the federal reserve rate at any of those meetings. According to CME Group’s FedWatch tool, the most likely times that we’ll see a rate hike could be at the following meetings:

• March 16
• June 22
• July 17
• December 22

Bottom line

The federal funds rate is one of the levers that the Federal Reserve uses to tinker with the economy. Specifically, it’s the rate banks use to lend each other money each night to make sure they meet reserve requirements. This impacts you as a borrower because banks take the federal funds rate into consideration when setting the interest rates of their products, including personal loans.

If the federal funds rate increases—as it’s expected to in 2022—then you’ll have to pay slightly more to borrow money. If you’ve been meaning to consolidate your debt or finance a big purchase, now may be the time to apply for a personal loan if you’re able, before rates rise.

Related: Best Low-Interest Personal Loans