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Economy 101: Interest Rates

Interest is what you pay lenders for the use of their money. It is the price of a loan expressed in an annual percentage rate. There are a plethora of interest rates, some of which get more attention than others. Here are three interest rates of key interest to American consumers.

Prime Rate

One important rate is the prime rate, the interest rate at which banks lend "floating rate loans" to business firms. These loans are "floating" because they move up and down in accordance with the prime rate during the life of the loan. Credit card rates are often tied to the prime rate as well, and it is for these two reasons that many other loan rates will move up and down when the prime rate rises or falls.

The Federal Funds Rate

When you hear on the news that Federal Reserve Chairman Ben Bernanke has raised or lowered interest rates, the rate in question is the Federal Funds Rate. This is the interest rate that banks charge when lending very large balances of money to each other through the Federal Reserve System. It is called the Federal Funds Rate because the money is transferred through the Federal Reserve System.

The Federal Reserve does not directly control the Federal Funds Rate, but it does control the Federal Funds nominal (target) rate through open market operations, the buying and selling of government securities on the open market. The Federal Funds effective (actual) rate then is the weighted average of interest rates that banks charge each other based upon market forces. When you hear a rate quoted in the media, it is generally the target rate that is being discussed.

U.S. Treasury Bill Rate

U.S. Treasury bills are short-term IOU's sold by the U.S. government in denominations that range from $1000 to $5 million. Typically, Treasury bills, or "T-bills," are purchased by banks, funds, and investors as short-term, interest-bearing vehicles in which to park large sums of money. T-bills, which commonly mature in one month, three month, and six month periods, are auctioned at a discount from their mature value.

For instance, a T-bill with a value of $10,000 may be sold for $9,400. When the bill matures, the government would pay you back the full $10,000, earning you $600 over the term of the bill. The difference between the amount paid and the value of the bill is called the Treasury bill rate. In this example the difference is $600, which is 6 percent of $10,000.

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