7 Things You Can Do To Lessen The Sting of Higher Interest Rates
Rising rates certainly pose challenges. But they also offer unique opportunities to save.
It’s easy to look at rising interest rates and see nothing but the potential for personal financial crises. Credit cards will charge more. It will be harder to get or refinance a mortgage. The average American carries just over $90,000 in debt and those debts could be harder to dig out of if their interest rates rise.
But, as Torrance, CA financial planner Tara Tussing Unverzagt notes, rising interest rates can offer opportunity.
“I seem to be the only person excited about interest rates going up,” she says. “If you aren't debt-driven, having higher interest rates means your savings, such as money market funds and bond investments, are earning more. That’s exciting.”
So it’s not all doom and gloom. While rising interest rates certainly pose challenges, financial planners and experts recommend reducing debt and seizing readily available chances to grow your savings. Here’s what they recommend.
1. Investigate Your Rates
As a first step, scrutinize your loan statements and figure out what types of debt you have. Loans either have fixed or variable interest rates. With some minor exceptions, fixed-rate loans don’t change. If you have a 5% fixed-rate mortgage or personal loan, the rate stays at 5% for the entirety of the loan, barring penalties for missed or late payments. Fixed-rate credit cards are rare and not really fixed; they can raise rates with 45 days written notice. Really, though, the takeaway here is that you don’t need to worry about fixed-rate loans. They’re not going to change and rising interest rates make it less likely you can shop around for a better rate
Variable rates, however, you need to keep a close eye on. Variable rates rise and fall depending on interest rate benchmarks, chiefly the Federal Funds rate set by the Federal Reserve System. Mortgages, car loans, student loans taken out prior to July 2006, and, especially, credit cards, can have variable rates. The average credit card interest rate is right now 18.97%. But Howard Dvorkin, chairman of Debt.com and a personal finance guide, predicts rates will shoot up over 20%.
“When the interest rates went down, some credit card companies never reduced their interest rates,” he says. “Their cost of lending went down substantially. It was near zero. But they never reduced it. They just took all that money in profit. Now they have an excuse to raise rates. ‘Well, the interest rates went up, so we are gonna bump our interest rates.’”
2. Tackle Credit Card Debt Early and Often
Right now, the average American credit card balance is $5,525. If that’s your situation, time and compound interest are your greatest enemies. Defeating them requires sacrifice. You need to aggressively attack credit card balances, starting today. If you pay $100 per month for a $5,525 balance accruing 20% interest it will take 13 years and cost nearly $10,000 in interest to pay off that card. This is assuming you stop making purchases on it, which almost no one ever does. Bumping it up to $110 monthly payments shaves that down by almost four years and about $6,550 in interest.
“If you have outstanding credit card bills, never pay the minimum payment,” Dvorkin says. “Pay triple the minimum payment. The minimum payment is designed to keep you in debt. That's the purpose. Seventy percent or more of your minimum payment is designed to pay interest, and you're only putting 30% of your minimum payment to the principal.”
3. Use Balance Transfers Wisely
Balance transfers can be a great way to consolidate debt and lock in a lower interest rate. But be wary. “If you’re looking at a transfer with a zero-rate offer, make sure that you know what you're getting yourself into,” Dvorkin warns.
The credit card companies aren’t making these 12-18 interest-free months offers out of the goodness of their hearts. Proceed with caution. You’ll probably have to pay a transfer fee, 2-5% of the balance. A 5% fee on a $5,525 balance is $276.25. That’s a hard pill to swallow, even if it’s far less than what you would pay in interest over time. The bigger problem, however, is how you’ll handle your suddenly paid-off credit card. It’s imperative to resist the temptation to use it for purchases. If you keep racking up charges on the original card and don’t substantially pay down the transferred balance on the second, you’ll wind up in a worse position than before.
4. Lock Down a HELOC ASAP
If you own a home, Dvorkin recommends establishing a Home Equity Line of Credit, aka a HELOC, as soon as possible. “Establish it now so you don't have to run around like a crazy man to establish one down the road,” he says. With higher rates driving down mortgages and refinances, banks are eager to lend.
HELOCS are revolving sources of funds that use the equity of your home as collateral, which means terms are more favorable than unsecured loans. Dvorkin recommends opening a HELOC quickly but waiting as long as possible to take the money out. Yes, you can pay off a high interest credit card with a relatively low interest withdrawal from a HELOC. But, like the balance transfer advice above, unless you commit to not using the card again, you’re in danger of getting trapped in a high interest rate debt cycle that’s almost impossible to wiggle out of.
“A lot of people leave their credit cards open, and then charge again, charge 'em up again over a couple years,” he says. “I see that time and time again. Then they have to pay off their credit cards at very high interest rates. So don't use your HELOC unless you have to.”
5. Investigate Mortgage Rates
If you’re shopping for a home, Wisconsin financial advisor Elliott Appel says you may want to compare the costs of an adjustable rate mortgage, or ARM, and a fixed rate mortgage. In the past few years, adjustable rate mortgages did not make sense when people could lock 30 year rates for under 3%.
But now that rates are up, if you don't plan to be in a home more than a few years, a 7/1 or 10/1 ARM, where the rate is fixed for seven or 10 years before adjusting to a variable rate. If you’re sure your purchase isn’t your forever home. “Many people don't end up living in their home for more than 10 years, so an ARM might lower your payment while still locking in the payment for a set amount of time,” Appel says.
6. Downsize Your Home Search
As mortgage rates go up, most likely house prices will come down. But as Unverzagt notes, getting caught in the transition is painful.
“If you're looking for a house now, you may want to rent for a while or downsize what you planned to buy to reduce the loan and the impact of the interest,” she says, adding that she cautions against shortening the term for a lower rate unless you are secure that you can pay the monthly bill and your job is rock solid secure.
“Better to have the longer term and higher interest and pay extra every month to pay off the mortgage early,” she says. “If anything happens to decrease your income or increase your expenses, you'll appreciate the buffer room.”
7. Rethink Your Investments (But Keep Your Emergency Fund Liquid)
Operating under the belief that interest rates will continue to rise for 12 to 24 months, Unverzagt says she’s moving her clients’ heavier cash holdings into short-term bonds. “You can get a one-year treasury for almost 3%,” she notes. “If you don't need that money for a year, this is a great move right now.”
While it’s a good move for money overall, it’s a bad place to park your emergency fund. “You could sell before maturity in a year but you'd lose money doing so,” Unverzagt says.
Instead, keep your emergency/contingency fund in cash so they’re available for emergencies. But if you’re building a chunk of cash for a big purchase you’re planning for one to five years in the future, those goals are perfect for sticking in a treasury while you wait.