How Interest Rates Work: From the Fed to Your Wallet
An interest rate is the price of borrowing money. The Federal Reserve sets a benchmark, and banks build card, loan and savings rates on top of it.
An interest rate is the price of borrowing money. It is written as a percentage of the amount per year. Borrow $1,000 at 10% and you pay about $100 a year. Save $1,000 at 4% and the bank pays you about $40. Almost every money decision you make, from a credit card to a mortgage to a savings account, depends on one.
This guide follows the chain from the Federal Reserve to your monthly payment. Each step has an interactive example you can try.
What is an interest rate?
Interest is what a lender charges for the use of money over time. The lender gives up the chance to use that money elsewhere and takes the risk you won’t pay it back. Interest pays for both.
The same idea works in reverse when you save. A bank pays you interest because it lends your deposits to other people at a higher rate. The difference between the two rates is how the bank earns money.
Who sets interest rates?
In the U.S., the starting point is the Federal Reserve. Eight times a year, its Federal Open Market Committee (FOMC) sets a target range for the federal funds rate. That is the rate banks charge each other for overnight loans.
On September 16, 2026, the committee raised that range by 0.25 percentage points to 3.75%–4.00%, by a 12–0 vote. Its next decisions are due on October 28 and December 9, 2026 (what to expect).
The Fed does not set your mortgage or card rate directly. Banks do. But most of those rates are built on top of the Fed’s benchmark:
| Rate you see | How it is usually set | How fast it follows the Fed |
|---|---|---|
| Credit cards | Prime rate plus a margin | Within one or two billing cycles |
| Variable-rate loans | A benchmark plus a margin | At the next reset date |
| New fixed mortgages | Long-term bond yields, which react to Fed expectations | Often before the Fed even moves |
| Savings accounts | Set by each bank to compete for deposits | Weeks to months, often only partly |
| Your existing fixed loan | Locked in when you signed | Never changes |
Why does the Fed raise or lower rates?
The Fed has two goals set by Congress: stable prices and maximum employment. “Stable prices” means inflation of about 2% a year. Interest rates are its main tool for both goals.
- To cool inflation, it raises rates. Borrowing costs more, so people and companies spend less. Lower demand slows price increases.
- To support jobs, it cuts rates. Cheaper borrowing encourages spending and hiring.
In September 2026, U.S. consumer prices were 3.7% higher than a year earlier, according to the Bureau of Labor Statistics. That is almost double the 2% goal, which is why the Fed is raising rates rather than cutting them. Gasoline alone rose 9.1% in September.
How does a rate change reach your wallet?
Through every loan you take out after the change. The effect is bigger than most people expect, because interest is charged on the whole balance, every month, for years.
On a $300,000, 30-year fixed mortgage:
- At 6.5%, the payment is about $1,896 a month.
- At 7.5%, it is about $2,098 a month.
- That one percentage point costs about $201 a month, or $72,500 over the life of the loan.
Change the numbers yourself in the interactive loan calculator. Try a 15-year loan to see how the total interest drops.
What does it mean for your savings?
Higher rates are good news for savers, but only if they beat inflation. The number that matters is the real interest rate: your rate minus inflation.
- A savings account paying 4% while inflation is 3.7% grows your buying power by only about 0.3% a year.
- Cash under a mattress loses 3.7% of its buying power every year at that inflation rate. After 10 years, $10,000 buys what about $6,954 buys today.
See how inflation shrinks cash, then look at how compound interest grows money over time. Together they show why earning a rate above inflation, for many years, matters so much.
APR, APY and other terms to know
- APR (annual percentage rate): the yearly cost of a loan, including some fees, without compounding.
- APY (annual percentage yield): the yearly return on savings including compounding. 4% compounded monthly is an APY of about 4.07%.
- Fixed rate: stays the same for the whole loan.
- Variable rate: moves with a benchmark, so your payment can change.
- Basis point: one hundredth of a percentage point. A “25 basis point hike” is 0.25 points.
The short version
- Interest is the price of money over time.
- The Fed sets the benchmark; banks build your rates on top of it.
- The Fed raises rates when inflation is high, as it is now, and cuts them when jobs are at risk.
- A one-point change can cost or save you hundreds a month on a big loan.
- For savers, only the rate above inflation makes you richer.
This guide is educational and is not financial advice.
Frequently asked questions
What is an interest rate in simple words?
It is the price of using someone else's money. If you borrow $1,000 at 10% a year, you pay about $100 a year for the privilege. If you save, the bank pays you interest for using your money.
Who sets interest rates?
In the U.S., the Federal Reserve sets a target for the federal funds rate, the rate banks charge each other overnight. Banks and lenders then set their own rates for cards, loans and savings, mostly based on that benchmark.
Why does the Fed raise interest rates when inflation is high?
Higher rates make borrowing more expensive and saving more attractive. People and businesses spend less, demand cools and price increases slow down.
What is the difference between APR and APY?
APR is the yearly rate on a loan without compounding. APY is the yearly return on savings including compounding, so it is slightly higher than the plain rate when interest is added monthly.
What is a real interest rate?
It is the interest rate minus inflation. A savings account paying 4% when inflation is 3.7% has a real rate of about 0.3%, so your buying power barely grows.