Interest rates have been a hot topic — and for a good reason. Whether you’re buying a home, running a business or simply watching the headlines, its clear rates have shifted dramatically in recent years. This article breaks down how interest rates are determined and what drives those changes.
How are interest rates determined?
Interest rates across the U.S. economy are heavily influenced by the federal funds rate, which is the target interest rate set by the Federal Reserve (Fed) for overnight lending between banks. The actual rate used for overnight lending is called the Secured Overnight Financing Rate (SOFR), which follows the federal funds rate set by the Fed. While this rate doesn’t directly apply to borrowers, it serves as a benchmark for many other interest rates.
Lenders typically add a spread to this SOFR base rate to cover costs and risks and earn a return. For example, if the SOFR rate is 4%, a bank might charge 6% on a consumer loan — the 2% difference is the bank’s margin, which is used to cover their costs and make a profit.
What drives the Fed’s interest rate decisions?
In the table below, you can see some of the main factors the Fed takes into consideration when determining whether to raise, cut or leave the federal funds rate as-is. The Fed typically meets eight times per year (approximately every six weeks) to review economic conditions and make the interest rate determination.
| Factor | Impact on rates |
| Inflation | Higher inflation may encourage the Fed to raise rates; lower inflation may encourage lower rates. |
| Employment | Higher unemployment may encourage the Fed to lower rates; lower unemployment may encourage higher rates as low unemployment can lead to inflation. |
| GDP growth | Weak growth may encourage the Fed to lower rates; strong growth may encourage higher rates. |
| Consumer spending | Slowing consumer spending may encourage the Fed to lower rates; increased spending may encourage higher rates. |
| Political pressure | The Fed is an independent board — political pressure should have little to no impact. |
What is the Fed trying to achieve with rate changes?
The Fed has a dual mandate:
- Price stability (as of 2025, the general guideline was to aim to keep inflation around 2%).
- Maximize employment.
| The Fed raises rates to: | The Fed lowers rates to: |
| Slow down the economy to reduce inflation. | Stimulate the economy during slowdowns or recessions. |
| Higher rates make borrowing more expensive (mortgages, credit cards, business loans), which reduces spending/investments and, therefore, slows spending, bringing down prices. | Lower rates make borrowing cheaper and saving less attractive, encouraging spending/investments and, therefore, boosts demand, supports job growth and helps keep the economy expanding. |
Why have rates changed so dramatically in recent years?
The table below highlights some major contributors to interest rate decisions during recent years.
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