The Impact of the Federal Reserve’s Decision
On September 18, 2024, the Federal Reserve reduced interest rates by 50 basis points (0.5%). This decision made headlines across online media, TV, newspapers, and magazines. But why was it such a big deal? To understand the significance, you first need to grasp the concept of interest rates.
What Are Basis Points?
In finance, a basis point (bp) is a unit of measurement equal to 1/100th of 1% (0.01%). So, when the Federal Reserve lowers rates by 50 basis points, it means a reduction of 0.5%. The reason this move garners attention is that lower interest rates make borrowing more affordable, encouraging people to take out loans for major purchases like homes and cars.
What Are Interest Rates?
Interest rates determine the cost of borrowing money and the returns on savings. When you take out a loan, the interest rate dictates how much extra you’ll have to pay back. Conversely, when you deposit money in a savings account, the interest rate determines how much your money will grow over time.
How Interest Rates Affect Loans
A lower interest rate reduces the cost of borrowing, making it cheaper to take out loans. This is why lower rates often lead to increased spending on big-ticket items.
How Interest Rates Affect Savings
When you save money in a bank or financial app, the institution pays you interest. Higher interest rates mean greater earnings on your savings, helping your money grow over time.
In short, an interest rate, expressed as a percentage, represents:
- The cost of borrowing money (loans)
- The earnings from saving money (deposits)
Banks and lenders express interest rates in different ways, including:
- Simple interest
- Compound interest
- Annual Percentage Rate (APR)
Most loan agreements specify both the interest rate and the APR.
How Interest Is Calculated
The way interest is calculated affects how much you pay on a loan or earn on savings. Interest can be simple or compound, with the latter often leading to higher costs over time.
Simple Interest
Simple interest is calculated only on the original loan amount (principal). The formula is:
Simple Interest = P × r × n
Where:
- P = Principal (loan amount)
- r = Interest rate (as a decimal)
- n = Loan term (in years)
For example, if you take out a $10,000 loan at 5% simple interest for five years, your total interest would be:
$10,000 × 0.05 × 5 = $2,500
Your total repayment would be $12,500.
Compound Interest
Compound interest, on the other hand, is calculated not just on the principal but also on the accumulated interest. This means you end up paying more over time. The formula is:
Compound Interest = P × (1 + r)ⁿ – P
Using the same $10,000 loan with 5% interest compounded annually, your total cost would be:
$10,000 × (1.05)⁵ – $10,000 = $2,833.59
Total repayment: $12,833.59
Since compound interest grows over time, it benefits savers but costs more for borrowers.
Types of Interest Rates
When choosing a loan or savings account, it’s important to understand the different types of interest rates:
Nominal Interest Rate
The nominal interest rate is the stated annual percentage rate (APR). For example, if a high-yield savings account advertises 5% interest, that’s its nominal rate. However, inflation affects the real earnings from this rate.
Real Interest Rate
The real interest rate accounts for inflation. It is calculated as:
Real Interest Rate = Nominal Interest Rate – Inflation Rate
For instance, if inflation is 3%, the real return on a 5% savings account would be:
5% – 3% = 2% (actual earnings).
Effective Interest Rate
The effective interest rate considers how often interest is compounded. This gives a more accurate picture of potential earnings in a savings account.
Fixed vs. Variable Interest Rates
When borrowing money—especially for a mortgage—you’ll often choose between fixed and variable interest rates.
Fixed Interest Rate
A fixed-rate loan has a set interest rate that remains the same for the loan’s entire term. For example, a 30-year mortgage at 5% means you’ll pay 5% interest every year until the loan is fully repaid.
Variable Interest Rate
A variable-rate loan starts with a fixed interest rate for a certain period but later adjusts based on market conditions. For example, a mortgage might start at 5% for two years, then fluctuate based on an index like the S&P 500. If the index rises, so does your interest rate. If it falls, your rate decreases.
While some borrowers hope for lower rates in the future, variable interest rates can be risky—especially if they increase significantly.
Why Understanding Interest Rates Matters
Knowing how interest rates work helps you make informed financial decisions. When the Federal Reserve changes rates, you’ll understand how it affects borrowing, saving, and overall economic conditions. Whether you’re taking out a loan or growing your savings, being aware of interest rates can help you manage your finances more effectively.
