# Understanding the Overnight Rate and Its Economic Impact

## What Is the Overnight Rate?

The overnight rate is the interest rate for short-term loans between [depository](https://www.investopedia.com/terms/d/depository.asp) institutions in the overnight market. Banks often have to take extremely short-term loans to meet reserve requirements, and many central banks (including the U.S. Federal Reserve) target this interest rate in setting monetary policy.

In most circumstances, the overnight rate is the lowest available interest rate, and as such, it is only available to the most [creditworthy](https://www.investopedia.com/terms/c/credit-worthiness.asp) institutions. When a central bank adjusts the overnight rate, the changes are eventually passed on to other loans and credit products.

### Key Takeaways

*   The overnight rate is the interest rate at which banks lend to each other to meet reserve requirements.  
    
*   This rate is the lowest interest available and is only accessible to the most creditworthy institutions.  
    
*   It serves as an indicator of short-term interest rate trends and economic health.  
    
*   Changes in the overnight rate influence borrowing costs for consumers as banks adjust their own rates.

![Overnight Rate (Federal Funds Rate)](https://www.investopedia.com/thmb/G5qAZRXoVwYv2r_DuAeXMkz8W7Q=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/overnightrate.asp-final-181516f335c34a87ba1f3421e0df538b.png)

*— Investopedia / Jessica Olah*

## Understanding the Mechanics of the Overnight Rate

 A bank's funds change daily due to lending and customer deposit and withdrawal activities. A bank may experience a shortage or surplus of cash at the end of the [business day](https://www.investopedia.com/terms/b/business-day.asp).

Banks with extra funds often lend overnight to those with shortages to meet [reserve requirements](https://www.investopedia.com/terms/r/requiredreserves.asp). These requirements ensure that the banking system remains stable and liquid.

The overnight rate allows banks to efficiently access short-term funds from central banks. As the overnight rate is influenced by [the central bank of a nation,](https://www.investopedia.com/articles/03/050703.asp) it can be used as a good predictor for the movement of short-term interest rates for consumers in the broader economy. The higher the overnight rate, the more expensive it is to borrow money.

The rate increases when [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) decreases (when loans are more difficult to come by) and falls when liquidity increases (when loans are more readily available). As a result, the overnight rate is a good indicator of the health of a country's overall economy and banking system.

> **Important**
>
> As of July 2024, the Federal Funds rate sits at a rate of 5.33%.

## How the Overnight Rate Influences the Economy

Most consumers aren't familiar with the overnight rate due to limited media coverage. While it indirectly affects finances, it's not directly impactful.

When the overnight rate rises, banks incur higher costs and may increase long-term rates, like mortgage rates. When the overnight rate increases, it becomes more expensive for banks to settle their accounts. To compensate, they often raise longer-term rates—usually mortgage rates.

The overnight rate impacts consumer borrowing and the broader economy. In the U.S., the Federal Reserve uses open-market operations to influence the overnight rate, affecting jobs, economic growth, and inflation. In turn, the overnight rate affects employment, economic growth, and inflation. This rate has been as high as 20% in the early 1980s and as low as 0% after [the Great Recession](https://www.investopedia.com/terms/g/great-recession.asp).

## Is the Bank Rate the Same as the Overnight Rate?

No, the bank rate and the overnight rate are not the same. The bank rate is also known as the discount rate, which is the rate that banks can borrow from the central bank. The overnight rate, also known as the federal funds rate, is [the rate at which banks can borrow from one another](https://www.investopedia.com/federal-funds-rate-7097323).

## Why Do Banks Borrow Overnight?

Banks are required by the central bank to keep a minimum amount of reserves to ensure liquidity in the banking sector. The reserves of banks fluctuate depending on customer withdrawals and deposits. When banks have a shortfall and cannot meet their reserve requirement, they will borrow from banks with a surplus to do so.

## How Does the Overnight Rate Affect the Prime Rate?

When the overnight rate is increased by the central bank, it becomes more expensive for banks to borrow money from one another, increasing their total cost. To make up for this increase in costs, banks increase their prime rates, which makes borrowing money for customers more expensive. In essence, banks pass the increased cost onto the consumer.

## The Bottom Line

The overnight rate is the interest rate at which banks lend to one another when they have a shortage in the reserves. Most consumers aren't aware of the overnight rate and what it is, but it plays a key role in the economy. It can range as high as 20%, like during the 1980s, or 0%, as it did after the Great Recession.

Central banks target the overnight rate when they set monetary policy, and those adjustments are passed on to consumers in the form of higher or lower interest rates. Ultimately, those monetary policies affect the levels of inflation, employment, and consumer spending throughout the wider economy.

> **Article Sources**
>
> 1.  Federal Reserve Bank of St. Louis. "[Federal Funds Effective Rate](https://fred.stlouisfed.org/series/FEDFUNDS)."