It’s been relatively inexpensive for consumers to borrow money and pay interest on loans for the last decade. But that's about to change, possibly as soon as this month.
The U.S. Federal Reserve has kept interest rates hovering at historic, near-zero lows for nearly seven years and hasn't raised rates since 2006. With interest rate changes quickly approaching, experts are advising consumers not to panic. “This Fed rate increase will probably be a marathon, not a sprint,” said Matt Schulz, senior industry analyst at CreditCards.com.
The Fed's rate increases will be slow and gradual. The first hike, likely a quarter of a percentage point, will get a lot of attention, but it's unlikely to have a significant impact on your household budget.
“Consumers won’t even notice,” said Greg McBride, chief financial analyst at Bankrate.com.
However, what will have a greater effect on consumers' wallets and purses is the culmination of a series of rate hikes over 12 to 18 months. The best course of action? In general, consumers should take steps now to reduce debt. Then households will begin to notice. The cumulative moves will have a significant effect on adjustable-rate mortgages, credit card rates and home equity lines of credit, McBride said.
The Fed's inevitable interest rate hike will affect average consumers in three key areas: mortgages, credit cards and bank loans. The central bank's action could begin as soon as next Wednesday. Here's what you can do as the window of opportunity narrows:
1. Refinance The Mortgage
Consumers with adjustable-rate mortgages (ARMs) should take action now, or have a game plan to pay down the loan before big payment increases start coming their way. The best bet is to refinance into a fixed-rate mortgage, McBride advised, which are still hovering around 4 percent.
“Those are opportunities that exist now, but may not persist once the Fed starts raising interest rates,” McBride said.
The average rate on a 30-year fixed-rate mortgage has been at record lows since the Federal Reserve took steps to revive the U.S. economy following the 2007-09 financial crisis. As the central bank prepares to move away from crisis-level rates, lenders will quickly begin to set mortgage rates based on their expectations for future inflation and interest rates.
The benchmark 30-year fixed-rate mortgage edged up to 4.05 percent from 4.03 percent, according to Bankrate's Sept. 2 survey of large lenders. That’s down from 4.1 percent four weeks ago and 4.24 percent a year ago.
Consumers also could refinance into one of the other hybrid ARMs to buy another five to seven years of fixed rates, which currently hover in the low 3 percent range. The rate on the benchmark 5/1 ARM (a fixed rate for the first five years and then adjustments thereafter) rose to 3.23 percent from 3.16 percent Sept. 2.
2. Chip Away At Debt
Now is also an opportunity to chip away at variable-rate debt before interest rates begin to climb, including credit cards, student loans, auto loans and home equity lines of credit.
Here’s the breakdown of what a Fed hike would cost consumers:
Let’s assume a 15 percent annual percentage rate (APR), which is the current average for new credit card offers: On a $5,000 balance, with a 15 percent APR and a $150 per month payment, interest would total $1,508.52 and it would take 44 months to pay off the balance.
If the balance and the payment remain equal, but the interest rate is increased by 0.25 percent, which is in theory what would happen if the Fed raises rates by 0.25 percent, $36 would be added to the interest total. For example, if the Fed raised rates a quarter-point, a $5,000 balance with a 15.25 percent APR and a $150 per month payment equals $1,544.74 in interest over 44 months.
Although it’s not a huge amount, where it starts to add up is if the Fed continues to raise rates over the course of the next two years. For instance, if the Fed raises rates a full percentage point over time a $5,000 balance with a 16 percent APR and $150 per month payment equals $1,656.82 in interest over 45 months.
If the APR increases from 15 percent to 16 percent, roughly $150 in extra interest is added to the balance versus the initial $36 increase.
Meanwhile, on a $25,000 loan, the effects would be minimal at first because a quarter of a percentage point translates to only a few dollars a month more. “A quarter of a percent move is pretty inconsequential,” McBride said. But over the course of 18 months or two years, in a more notable fashion, that’s when it starts to make a dent in the household budget, McBride warned.
Borrowers who took out home equity lines of credit during the housing boom should be especially mindful of when the 10-year draw period comes to an end. A draw period allows a holder of a line of credit to withdraw money for a period of 10 years. Once the draw period is over, the borrower can no longer tap into the line of credit.
Once the 10-year period is up, borrowers are no longer paying just the interest on the loan. The monthly payments increase to cover interest expense and the principal balance over the remaining term of the loan.
That produces a significant payment increase completely independent of interest rates, McBride said.
3. Snag Zero-Percent Credit Card Offers
Consumers should also try to snag zero-percent introductory rates and balance-transfer offers on credit cards -- and do it now. As the Fed moves away from zero-percent interest rates, credit card issuers act accordingly and raise their interest rates. They also will be less likely to offer zero-percent rates.
“There’s a decent chance that zero-percent offering might become a bit of an endangered species soon,” Schulz said.
Those thinking of doing a balance transfer should take action as soon as possible. If banks won’t be borrowing for free anymore, they might not let their cardholders do it either.
But if the zero percent offers stick around, banks may end up going a different route and raise fees associated with those zero-percent offers. Instead of having a 3 percent balance transfer fee associated with a card, it might be 4 percent or 5 percent. “That’s significant as well,” Schulz said.