Basis points and the effect on your finances
Eight times each year the Federal Open Market Committee (FOMC) meets to discuss the nation’s monetary policy and set the federal funds rate, which dictates the interest banks charge each other for short-term loans.
Each FOMC meeting receives broad publicity and is watched closely by investors and financial institutions as a change in interest rates can impact the value of securities and a broad range of financial instruments.
From Wall Street to Main Street, interest rates affect almost everyone
On the other end of the spectrum, the people on “Main Street” generally don’t follow the FOMC’s every move. News of a 10- to 25-basis point change in the federal funds rate rarely registers with Jane and John Doe. Perhaps it should.
A basis point is equal to 0.1 of 1 percent and is used to describe interest rate changes. For instance, if you have an adjustable rate mortgage that is 5 percent and the FOMC announces a 25-basis point hike in the federal funds rate, that increase will eventually be reflected in your mortgage interest. Of course, if the federal funds rate is reduced, interest on that same loan will come down.
What does a change in interest rates mean in “real” dollars?
Let’s say you have a 30-year, $100,000 loan at an interest rate of 5 percent. Plugging the numbers into the equation, you have a monthly payment of $536.82. If your interest rate is boosted by 25 basis points to 5.25 percent, your monthly payment bumps up to $552.20, a difference of about $15.38 per month.
Not a big deal, right? Think again.
If you multiply $15.38 per month over a 30-year payback, you would spend more than $5,500 in additional interest alone. If you apply the same math to a $500,000 loan, the extra interest you would pay balloons to $27,500 over the life of the loan!
All credit instruments are affected by the federal funds rate
While mortgages are the most widely discussed loans impacted by changes in the federal funds rate, all loans, even those without variable rates, are affected. When basis points move up or down, what you would pay to secure a car loan today might be different tomorrow. Home improvement loans, business loans, credit cards, personal lines of credit, etc. are subject to changes when basis rates move up or down.
It’s not just borrowing that is impacted by a move in basis points
As noted earlier, securities can increase or decrease in value when interest rates move, whether it involves an impact on a company’s bottom line or a change in interest and dividend payments. Even the time-honored passbook savings accounts will pay more or less to customers by way of a formula that ties back to the federal funds rate.
Next time you hear the Federal Open Market Committee is meeting, check out what, if any, changes they make to the federal funds rate. It may be a barometer of what you may expect for your own finances.