Outsmarting the Fed
Here's how to prepare your personal finances for the coming interest-rate hikes.
THERE AREN'T A lot of sure bets in the investing world, but here's one: Interest rates are heading up. Exactly when this will happen remains uncertain, but these days Fed-watchers are at an orange-alert level.
That means it's time for consumers to get ready for some pain.
But while preparation is certainly in order, most Americans need not panic. Unlike in 1994 — when the Fed raised rates a whopping three percentage points in just 12 months — Fed officials said they will raise rates at a "measured pace" this time around. And most experts believe the Fed will try merely to normalize rates back to a more neutral stance of 2% or 3%. With the fed-funds rate currently at just 1%, there's plenty of room for rate hikes before consumers really start to feel the pinch, says Keith Leggett, senior economist for the American Bankers Association.
Of course, plenty of Americans will feel the squeeze even with a small increase. According to the Federal Reserve, U.S. consumers have more than $2 trillion in debt — not including mortgage debt. That's nearly $20,000 per household. And a large portion of that debt — $755 billion — is revolving debt like credit-card obligations and home-equity lines of credit, whose rates will move higher as the Fed cranks up rates. Even a small hike could induce stress fractures on a family budget.
What should concerned consumers do? Prepare. "The worst thing consumers can do in this market is put off addressing the issue," says the ABA's Leggett. "If you are only making minimum payments on a credit card, for example, you are probably overextended."
If this described you, it's time to start budgeting and paying off debts. Here's a breakdown of how consumer debts will be affected by rate increases — and what you can do to soften the blow.
When the Fed increases the fed-funds rate, the prime-lending rate will follow. That, in turn, means interest rates on credit cards will rise. And be warned: Having a "fixed rate" Visa or MasterCard won't necessarily provide protection, warns Greg McBride, Bankrate.com's senior financial analyst. A "fixed rate" simply means the lender must give its customers 15 days written notice before raising rates. That's less than one billing cycle.
Consumers who carry a balance should start making a plan to protect themselves. First and foremost, now is the time to find ways to shed expenses and pay down debts more aggressively.
Another option is to consolidate debts at a lower interest rate. One way to do that is to tap home equity via a fixed-rate home-equity loan. As of May 18, interest rates on these loans averaged just 6.5%, according to Informa Research Services. Non-homeowners can shop around for a personal loan from a credit union or local bank. And at the very least, consumers can shift balances over to other credit cards with better terms. (Check out CardWeb.com for competitive offers.)
Home-Equity Lines of Credit
Home-equity lines of credit are also tied to the prime rate. A typical line of credit is priced at a half to a full point above the prime lending rate, which now sits at 4%.
Homeowners who've borrowed only a small amount of money and intend to pay it off over the next couple of years are probably in good shape. As we mentioned earlier, most experts agree that the Federal Reserve will raise rates slowly. And don't forget that the interest on money borrowed up to $100,000 is tax deductible. It's tough to find a better deal than that. (For more on home-equity lines of credit, click here.)
For folks who've run up big home-equity credit lines, Bankrate.com's McBride recommends refinancing the debt with a fixed-rate home-equity loan. Or, homeowners could refinance their primary mortgages and take out some cash in the process. The industry calls this a cash-out refinance. Interest rates for cash-out refis tend to be a bit lower than for home-equity loans, but the borrower will have to pay closing costs that could total a few thousand dollars. (For more on the advantages and disadvantages of tapping home equity, read our story.)
The average homeowner moves every seven or eight years. That helps explain the popularity of hybrid adjustable-rate mortgages (ARMs), which offer a fixed interest rate for the first, say, five or seven years, and then become variable. These loans tend to carry lower interest rates (anywhere from one-half to a full point or more lower) than 30-year fixed-rate loans.
Sometimes, however, homeowners decide to stay in their homes longer than planned. In today's environment, homeowner's who don't see moving boxes in their futures might instead refinancing their ARM with a fixed-rate mortgage. Don't wait until the ARM expires, warns Bankrate.com's McBride. While the rate on credit cards and lines of credit won't budge until the Fed acts, mortgage rates are already heading higher. That's because they follow the 10-year Treasury note, which climbs in anticipation of inflation and higher interest rates, he explains. The interest on a 30-year fixed-rate mortgage has climbed to 6.37% from a low of 5.41% back in March, according to Bankrate.com.
Even if you don't have a lot of debt, higher rates could still affect you should you seek credit in the future. As mentioned above, mortgage rates are rising. So future home buyers will find their money won't stretch quite as far. While a $250,000 30-year-fixed-rate mortgage with an interest rate of 6.5% carries a monthly payment of just $1,580, it jumps by $254 a month (or $3,048 a year) if that rate climbs just 1.5 percentage points. To figure out how much your dream home may cost in different interest-rate environments, check out our calculator.
Another place consumers might feel the pinch is at the auto dealership. If higher gasoline prices aren't bad enough, don't be surprised if it costs more to buy a car during the second half of the year. Between the imminent rate hikes and a stronger economy, auto makers have less incentive to offer consumers attractive zero-percent financing deals. Auto loans offered by lenders will also go up. Folks hoping for a new (or used) set of wheels by year-end may want to make their purchases sooner rather than later, so they can lock in today's deals before they're left in the dust.