One of the Federal Reserve’s main responsibilities is to establish the discount rate for member banks to pay for borrowing money. This affects the federal funds rate that each member bank charges and subsequently affects the prime rate that banks charge.
The federal funds rate refers to the overnight discount rate which the Federal Reserve charges to depository institutions. The discount rate is the rate federal banks are charged by the Federal Reserve.
The prime rate is the rate given to the banks best clients (i.e. large companies, investors with excellent credit standing and other commercial borrowers). An added duty of the Federal Reserve is to raise and lower reserve requirements for member banks. The above duties of the Federal Reserve directly affect the interest rate available to consumers.
The discount rate is set by the Federal Reserve board and ultimately put into place by the Board of Governors. There are 12 regional branches within the Federal Reserve and one of their main duties is to fund loans to lenders when they have minimal cash assets or are experiencing a financial difficulty. This is done to prevent lenders from becoming insolvent.
Why is the Discount Rate Important
Understanding the discount rate is important for various reasons. Among the most important being that the discount rate directly affects interest rates. The rates banks charge clients for loans is tied into the discount rate offered to the bank. Most of the capital banks have is not their own money. Most of the money lenders lend comes from the large institutions that fund their loans including large companies, 401K’s, high net worth individuals, life insurance companies and others.
The higher the interest rate the bank pays for these loans, the higher the rate consumers make. Being aware of the discount rate in the market, can help borrowers and investors make opportune investments at the right times, depending on the discount rate. This proves vital to consumer’s understanding of the market and their ability to make solid decisions.
Discount Rate Programs
There are three different discount rate programs and rates offered vary based on the party receiving the funding. All the depositories discount loans are secured.
Loans extended to primary and secondary credit lenders are typically for the short term, while seasonal credit lenders are extended to smaller depository institutions for the longer term. The Federal Reserve charges primary credit depositories the standard short-term interest rate, while the discount rate for secondary lenders is higher. Seasonal depositories discount rate is the average rate of the various market rates. The rates imposed to the banks depends on the banks history, their location, the businesses and individuals they serve, and their financial assets.
Larger banks that have been in business for a longer period of time, typically get better rates and programs offered to them. While in theory this makes it more difficult for smaller lenders to compete, it ensures that lenders that have a good history of making good decisions gets rewarded. The location and place of business of the lender might also affect the rates offered to them. Lenders offering services in a high net worth community with good credit borrowers will have a greater likelihood of getting offered the best rates. Because their borrowers have better financial histories and income, the chance of them defaulting is much smaller and therefore the banks that serve these clients is subsequently rewarded with great discount rates.
Understanding Discount Rate and Primary Rate
The primary credit rate is oftentimes called the “discount rate.” The primary rate is different than the different “discount rate.” The primary rate is given to either larger institutions or those with good credit. Secondary credit lender’s rates are higher than institutions that qualify for the primary rate by 50 basis points. Discount rates are not based on market rates, rather as mentioned above they are strictly based on the rate the board of governors approve. Rates typically change every 14 days.
Effect of the Discount Rate on the Economy
The Federal Reserve uses interest rates to incentivize growth, target inflation, and reduce unemployment in the market. Because interest rates greatly affect the cost of doing business and buying a house, the Federal Reserve will increase or decrease the discount rate based on the goals of the time period.
The last major world event that greatly altered the normal course of the federal reserve was the Great Recession of 2008. After the mortgage and real estate collapse of 2007 and 2008, the economy faltered and put many homeowners into default and into debt on previous agreements including on their mortgages and credit cards. To combat the recession, the Federal Reserve instituted historically low interest rates to promote borrowing. While qualification became more difficult for the average borrower, the cost to borrow money dramatically reduced and therefore allowed consumers to purchase property and products at lower prices with the lower rates.
The reduced low interest rates helped increase the ability of consumers to purchase property and afford financing. Particularly in periods where economic growth is weak, low interest rates can help consumers afford products and property that they likely would not be able to.