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When you need to borrow money, you usually go to a bank or a credit union. But when a bank needs to borrow money, where does it go? Thanks to the discount rate, they can go to the Federal Reserve for help.
The discount rate, which is one of several tools the Fed uses to carry out its monetary policy, is the interest rate that banks and other financial institutions pay when they borrow money from the Federal Reserve.
As a bank customer, you may not ever be directly impacted by the discount rate, but it still helps keep your money safe. Discount rates make it affordable for banks to borrow money, which helps them avoid collapsing in the event of major events like bank runs or panics.
Read more: Panic of 1907: The stock market crash that brought us the Fed
Discount rate definition
The discount rate is the interest rate the Federal Reserve charges on the money it lends to financial institutions, including banks, credit unions, and U.S. branches of foreign banks.
This interest rate, which is part of a lending program that's been around since 1914, is set with a strategic purpose. On one hand, the discount rate is slightly higher than what banks pay to borrow money from each other (known as the federal funds rate). On the other hand, it's low enough that banks will still turn to the Fed in times of need.
As a result, banks are incentivized to use each other as a first resource for financing, but they also have the Fed as an affordable alternative that prevents them from seeking high-risk loans.
There are three different types of Fed loans that have discount rates — primary credit, secondary credit, and seasonal credit — and the rate is different for each one. Most banks that borrow money from the Fed qualify for "primary credit," which is the loan program with the lowest rate.
Read more: Federal funds rate: What it is and how it affects you
How the discount rate works
Discount rates are tied to economic conditions. When the Fed adjusts interest rates in order to steer the economy, discount rates adjust as well.
For example, when the economy is stalling — usually signaled by low inflation and/or low employment — the Fed cuts the federal funds rate and the discount rate drops as a result. When inflation is rising above its target, the Fed increases the federal funds rate and the discount rate goes up too.
Discount rates only impact your bank or credit union when the institution needs to borrow money from the Fed, which doesn't happen very often.
Outside of significant, economically destabilizing events — think: the stock market crash of 1987, the Sept. 11 terrorist attacks, and most recently, the COVID-19 pandemic — borrowing has been limited.
But in order to recover from a major event, or to stave off other cash-shortage problems, financial institutions can turn to the Federal Reserve. Here's an overview of the terms they get when they take out a loan from the Fed:
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Funding speed: Same day as approval
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Fixed/Variable rate: Variable (adjusts if the discount rate changes)
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Loan amounts: No set limit
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Late penalty: Rate increase of 5 percentage points
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Prepayment penalty: $0
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Repayment terms: 1 day to 9 months
The discount rates on these loans can change as often as every 14 days, but rapid changes are uncommon. For example, the rate on the primary credit program stayed at 5.50% from July 2023 to August 2024.
Who controls the discount rate?
The discount rate is set by the 12 Federal Reserve Banks' board of directors. The board votes to recommend a rate, and then the Board of Governors of the Federal Reserve System must approve their recommendation.
In the past, each regional board set its own rates, but now they collectively adopt national rate changes. They determine the discount rate for primary credit based on a variety of factors, but the main consideration is the target range for the federal funds rate. Other influences include:
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Labor market conditions
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Consumer spending
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Housing affordability
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Inflation
The rate for secondary credit is 50 basis points above the primary credit rate. So, if the primary rate is 5%, the secondary rate will be 5.50%.
For the seasonal rate, the board uses a more complex formula that includes the rate on three-month CDs over the previous 14 days.
Read more: What is the Federal Reserve?
Why the discount rate matters
The discount rate is the main safety mechanism that prevents banks from falling short on cash reserves. If banks fall short, a number of bad things can happen, including:
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Rise in inflation and economic instability
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Loans and credit are less available to customers, or available with lower limits
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Rates and fees associated with borrowing increase
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Banks can collapse, causing customers to lose their uninsured deposits
One recent example is Silicon Valley Bank (SVB), which failed in 2023. Its failure was due, in part, to the fact that it had exhausted its main funding source and was not prepared to borrow from the Fed. On March 9, SVB saw a one-day bank run on $42 million in deposits. On March 10, the bank tried and failed to meet the Fed's requirements for a loan, and it collapsed that same day.
