There has been much talk of late about whether the Federal Reserve Board, a.k.a. “the Fed,” will raise interest rates before the end of the year, as it did last year.
The Federal Funds Rate, known less formally as the Fed Funds Rate, is the interest rate at which banks and other depository institutions lend money to each other. For all practical purposes, it’s the rate financial institutions pay to borrow money, which they in turn lend to consumers. In December 2015, the Fed raised the Fed Funds Rate from a range of zero to .25 percent to a range of .25 percent to .50 percent, which is where it still stands as of today.
A potential increase in banks’ cost of funds is fueling speculation that the consumer interest rates will follow suit, and indeed they might. But having said that, there is a number that plays a much larger role than the Fed Funds Rate in determining how much you pay in interest. And unlike the Fed Funds Rate, it’s even a number you have some control over: your credit score.
The difference in the Fed Funds Rate between last year and this year can be measured in what’s called “basis points.” A basis point is 1/100th of 1 percent, which means it represents a very small difference in the cost a bank pays to borrow money before lending it. Even if a bank decides to pass along the entire amount of an interest rate hike to their borrowers, the increase in the rate you pay would be much less than 1 percent.
By contrast, the difference in rates paid by people with low credit scores compared with those paid by high-scoring individuals is much, much higher than a few basis points.
The starkest comparison concerns auto-loan rates. A borrower with really good credit scores can pay almost zero percent interest for certain makes and models of cars. Conversely, a borrower whose score is just good enough to get a loan approval might pay a rate of more than 20 percent on the same car loan. As explained at the educational website CreditScoreQuiz.org, that could mean an increase of more than $5,000 in interest payments on a $20,000, 60-month auto loan.
Increases in mortgage interest rates are less stark, but their consequences in dollars and cents can nonetheless be eye-popping. For example, a borrower with great credit scores can get a 30-year fixed-rate mortgage loan for about 3.3 percent. On a $250,000 mortgage, the monthly payment would be around $1,096. Another borrower, whose credit is just good enough to get an approval for the same loan amount, would be charged an interest rate close to 5 percent. That translates to a monthly payment of about $1,325 for the same loan amount – or a total of more than $80,000 in additional interest over the life of the mortgage loan.
So if you’re concerned about avoiding higher interest rates, you’re better off not worrying about the Fed and instead focusing on improving your credit score. There are some great tips for doing so at YourVantageScore.com.