7 things you can do to ease the sting of higher interest rates
It’s easy to look at rising interest rates and see nothing but the potential for personal financial crises. Credit cards charge more. Getting a mortgage or refinancing is getting harder. The average American has a little over $90,000 in debt, and that debt could be more difficult to get rid of if interest rates rise.
But, as Torrance, CA-based financial planner Tara Tussing Unverzagt notes, rising interest rates can present opportunities.
“I seem to be the only person who’s excited about rising interest rates,” she says. “Unless you’re debt-driven, higher interest rates mean your savings, like money market funds and bond investments, earn more. That is exciting.”
So it’s not all doom and gloom. While rising interest rates certainly pose challenges, financial planners and pundits recommend reducing debt and embracing readily available opportunities to boost your savings. Here’s what they recommend.
1. Examine your prices
The first step is to check your credit statements and find out what types of debt you have. Loans have either a fixed or variable interest rate. With a few minor exceptions, fixed rate loans do not change. If you have a 5% fixed-rate mortgage or personal loan, the interest rate stays at 5% for the entire duration of the loan, barring penalties for missed or late payments. Fixed rate credit cards are rare and not really fixed; they can increase the prices with a written notice of 45 days. However, the advantage here is that you don’t have to worry about fixed rate loans. They won’t change, and rising rates make it less likely that you’ll be able to search for a better rate
However, you need to keep a close eye on variable interest rates. Floating interest rates rise and fall in response to interest rate benchmarks, primarily the Federal Funds Rate set by the Federal Reserve System. Mortgages, auto loans, student loans taken out before July 2006, and especially credit cards, may have variable interest rates. The average credit card interest rate is currently 18.97%. But Howard Dvorkin, chairman of Debt.com and personal finance advisor, predicts rates will rise by over 20%.
“When interest rates went down, some credit card companies never lowered their interest rates,” he says. “Your borrowing costs have come down significantly. It was close to zero. But they never reduced it. They just took all the money with them. Now they have an excuse to raise interest rates. ‘Well, interest rates have gone up, so we’re going to raise our interest rates.’”
2. Deal with 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 biggest enemies. Defeating them requires sacrifice. You need to attack credit card balances aggressively starting today. If you’re paying $100 a month for a $5,525 balance at 20% interest, it takes 13 years and almost $10,000 in interest to pay off that card. This requires you to stop making purchases, which almost nobody ever does. Upping it to $110 in monthly payments cuts that nearly four years and about $6,550 in interest.
“If you have outstanding credit card bills, you never pay the minimum payment,” says Dvorkin. “Pay triple the minimum payment. The minimum payment serves to keep you in debt. That’s the purpose. Seventy percent or more of your minimum payment is used to pay interest, and you only pay 30% of your minimum payment to the principal.”
3. Use credit transfers wisely
Balance transfers can be a great way to consolidate debt and secure a lower interest rate. But be careful. “If you’re considering a zero-fare transfer, know what you’re getting into,” warns Dvorkin.
The credit card companies are not making these 12-18 month interest free offers out of the goodness of their hearts. Proceed with caution. You will likely 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 tough pill, even if it’s far less than what you would pay in interest over time. However, the bigger problem is how you handle your suddenly cashed out credit card. It is imperative to resist the temptation to use it for purchases. If you keep accumulating fees on the original card and don’t significantly repay the transferred funds on the second, you’ll end up in a worse position than you were before.
4. Lock down a HELOC as soon as possible
If you own a home, Dvorkin recommends setting up a home equity line of credit, also known as a HELOC, as soon as possible. “Build it now so you don’t have to run around like a madman to start one later,” he says. As higher interest rates drive down mortgages and refinancing, banks are scrambling to lend.
HELOCS are revolving sources of finance that use your home’s equity as collateral, meaning the terms are more favorable than unsecured loans. Dvorkin recommends opening a HELOC quickly but waiting as long as possible to withdraw the funds. Yes, you can pay off a high-yield credit card with a relatively low-interest withdrawal from a HELOC. But like the balance transfer advice above, you run the risk of being trapped in a high-interest-rate debt cycle that you’ll find it difficult to break out of unless you commit to not using the card again.
“A lot of people leave their credit cards open and then charge them again over a couple of years,” he says. “I see that again and again. Then they have to pay off their credit cards at very high interest rates. So only use your HELOC if you have to.”
5. Research mortgage rates
If you’re buying a home, Wisconsin financial advisor Elliott Appel says you might want to compare the cost of an adjustable-rate mortgage, or ARM, and a fixed-rate mortgage. In recent years, adjustable rate mortgages didn’t make sense when people could lock interest rates in for 30 years at less than 3%.
But now that interest rates are going up, if you don’t plan on staying in a house for more than a few years, get a 7/1 or 10/1 ARM where the interest rate is fixed for seven or 10 years before it settles adjusts a variable interest rate. If you are sure your purchase is not your forever home. “A lot of people end up living in their house for no more than 10 years, so an ARM can potentially lower your payment and still block payment for a period of time,” Appel says.
6. Narrow down your home search
If mortgage rates rise, house prices will most likely fall. But as Unverzagt notes, getting stuck in transition is painful.
“If you’re looking for a home now, you might want to rent for a while or downsize your proposed purchase to reduce credit and the impact of interest rates,” she says, adding that she cautions against shortening the term to a lower one Sentence unless you are sure you can pay the monthly bill and your job is absolutely safe.
“It’s better to have a longer term, higher interest rates, and pay extra every month to pay off the mortgage early,” she says. “If anything happens that reduces your income or increases your expenses, you’ll appreciate the buffer space.”
7. Reconsider your investments (but keep your emergency fund liquid)
Unverzagt expects interest rates to keep rising for 12 to 24 months and says she is shifting her clients’ larger cash holdings into short-term bonds. “You can get a 1-year Treasury bond for almost 3%,” she notes. “If you don’t need that money for a year, now is a great move.”
While it’s a good move for money overall, it’s a bad place to park your emergency fund. “You could sell a year before maturity, but you’d lose money doing it,” says Unverzagt.
Instead, keep your emergency/emergency fund in cash so it’s available for emergencies. But if you’re building up a bunch of cash for a big purchase you’re planning one to five years in the future, these goals are perfect to keep in a treasury while you wait.