A strong economy and low unemployment numbers prompted the Federal Reserve to raise interest rates for the second time in four months. In the last decade, we have only seen three interest rate increases. The rate increases will result in new loans costing more and a much higher cost of carrying debt. With the Federal Reserve poised to increase rates multiple times this year, the increase in rates matters to those who have adjustable rate debt. Whether you have a variable rate mortgage, an equity line of credit on your home, or credit card debt, the impact of these rate increases can be both immediate and painful. Here is what you need to know.
Federal Reserve Rate Increases Directly Impacts Your Interest Rate
The Federal Reserve controls the Fed Funds rate, which is the rate banks charge each other for short-term and overnight loans. The Fed Funds Rate corresponds directly with the Prime Rate, which is the best rate banks offer their best customers. For much of the outstanding variable debt, the Prime Rate is the standard benchmark in the US, including most credit cards.
Fixed Versus Variable Rate Debt
Borrowing money involves either loans or lines of credit. Loans, which have a fixed loan amount and a fixed term, are more likely to offer a fixed rate of interest. Lines of credit, on the other hand, have a set amount available to borrow and allow you to borrow, pay back, and re-borrow without applying for more credit. These lines of credit are more likely to have variable rates of interest, which fluctuate based on the Prime Rate and traditionally feature lower payments, often interest only. These conditions encourage borrowers to leave debt outstanding, making you more vulnerable to rate increases.
Fixed rate debt offers the same interest for the entire term of the loan. When you get a fixed rate 30-year mortgage, unless you refinance or sell the home, the rate, payment, and time of the loan remain the same for 30 years. The benefit of a fixed rate, particularly with long-term debt, is that the interest rates, the economy, and other market conditions do not alter your loan or payment structure. The only factor which could alter the payment is an increase in the escrow, which includes taxes and insurance.
Variable rates, on the other hand, start out at a lower rate because the borrower takes the interest rate risk, instead of the bank. At the time you sign the loan, there is an initial rate based on the Prime Rate (or another benchmark rate) and a margin. The margin remains the same throughout the loan, based on the strength of the application. The better your credit and loan factors, the lower the margin. When the index or benchmark rises, the rate will rise correspondingly.
When Do Rates Rise?
Variable rate mortgages offer a fixed rate for a certain number of years and then will adjust, typically every year afterward, until you sell or refinance the loan. A five or seven-year fixed term with an annual adjustment is the most common terms for mortgages. In this case, 30 to 60 days before the loan’s anniversary, the rate will reset for the following year and lock in for the following twelve months. There is an upper limit on the increase, which can be as much as 5% in a single year.
Lines of credit or HELOCs use the home as collateral and offer adjustable rates based on Prime. The rate can be as low as Prime and still offers a low rate for most debt. The rate for most HELOCs rises the month following any rate increase by the Federal Reserve. There are typically broad limits on the amount of increase, which can occur.
Credit cards charge a margin plus the Prime Rate and adjust almost immediately. Within 30 days of a rate increase, you will see the rate rise on both existing balances and new purchases. By the next bill after an increase, you will see the interest charges rise in credit card bills.
Minimize the Damage
Rising interest rates have an exponential impact on credit card debt because the interest rates compound daily, instead of monthly, like most debt. In the last four months, you have experienced 0.50% interest rate increase with the prediction of an additional 0.50% before the year’s end. The result is that you are now paying an extra 0.50% on every dollar of outstanding credit card debt, every day.
Refinance: The least expensive option is to refinance debt into a fixed rate. It provides a long-term solution but can be difficult to qualify for if you already have a lot of debt, because you must qualify for the new loan based on credit score and income.
Roll debt into a lower rate loan or line of credit: Transferring credit card balances is one way to mitigate higher rates. Low and zero percentage offers are common for those with good credit, and you might be able to open new credit cards and get a zero percent offer for up to 21 months. Current credit cards with zero balances might also provide a source for a balance transfer. The challenge is that a balance transfer offers a short-term solution to a long-term problem. You may transfer small amounts of debt to lower rates, but it is not likely to provide relief for large debt balances. Also, consider the cost of the transfer fee and long-term rate after the promotion ends.
Debt modification: Struggling with payments before a rate increase can tip the scale towards debt modification. Negotiating a debt to pay off the balance can stop rising interest rates and lead to paying off balances sooner.