You've probably heard the news that the Federal Reserve has been raising its benchmark federal funds rate. The Fed doesn't directly control consumer interest rates, but changes to the federal funds rate (which is the rate banks use to lend funds to each other overnight within the Federal Reserve system) often affect consumer borrowing costs.
Forms of consumer credit that charge variable interest rates are especially vulnerable, including adjustable rate mortgages (ARMs), most credit cards, and certain private student loans. Variable interest rates are often tied to a benchmark (an index) such as the U.S. prime rate or the London Interbank Offered Rate (LIBOR), which typically goes up when the federal funds rate increases.
Although nothing is certain, the Fed expects to raise the federal funds rate by small increments over the next several years. However, you still have time to act before any interest rate hikes significantly affect your finances.
Adjustable rate mortgages (ARMs)
If you have an ARM, your interest rate and monthly payment may adjust at certain intervals. For example, if you have a 5/1 ARM, your initial interest rate is fixed for five years, but then can change every year if the underlying index goes up or down. Your loan documents will spell out which index your ARM tracks, the date your interest rate and payment may adjust, and by how much. ARM rates and payments have caps that limit the amount by which interest rates and payments can change over time. Refinancing into a fixed rate mortgage could be an option if you're concerned about steadily climbing interest rates, but this may not be cost-effective if you plan to sell your home before the interest rate adjusts.
It's always a good idea to keep credit card debt in check, but it's especially important when interest rates are trending upward. Many credit cards have variable annual percentage rates (APRs) that are tied to an index (typically the prime rate). When the prime rate goes up, the card's APR will also increase.
Check your credit card statement to see what APR you're currently paying. If you're carrying a balance, how much is your monthly finance charge?
Your credit card issuer must give you written notice at least 45 days in advance of any rate change, so you have a little time to reduce or pay off your balance. If it's not possible to pay off your credit card debt quickly, you may want to look for alternatives. One option is to transfer your balance to a card that offers a 0% promotional rate for a set period of time (such as 18 months). But watch out for transaction fees, and find out what APR applies after the promotional rate term expires, in case a balance remains.
Variable rate student loans
Interest rates on federal student loans are always fixed (and so is the monthly payment). But if you have a variable rate student loan from a private lender, the size of your monthly payment may increase as the federal funds rate rises, potentially putting a dent in your budget. Variable student loan interest rates are generally pegged to the prime rate or the LIBOR. Because repayment occurs over a number of years, multiple rate hikes for variable rate loans could significantly affect the amount you'll need to repay. Review your loan documents to find out how the interest rate is calculated, how often your payment might adjust, and whether the interest rate is capped.
Because interest rates are generally lower for variable rate loans, your monthly payment may be manageable, and you may be able to handle fluctuations. However, if your repayment term is long and you want to lock in your payment, you may consider refinancing into a fixed rate loan. Make sure to carefully compare the costs and benefits of each option before refinancing.
Also in this issue:
- Future of the Federal Estate Tax
- The Health-Wealth Connection
- What is a rollover IRA, and do I need one?
- Can I roll my traditional 401(k) account balance over to a Roth IRA?