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How to stay  ahead of rising interest rates

Jean Chatzky,
MONEY Magazine, October 2004

The heady days of cheap money and near undetectable inflation may be coming to an end. Since the Federal Reserve raised rates a quarter of one percent in June 2004, everyone, including your uncle Bob, has been predicting that the trend is now nowhere but up. "The good news is that we're starting from historic lows in short-term rates, and if the Fed sticks with its pledge to raise rates slowly, the pain should be spread out over several years rather than coming in a big bite," says Keith Gumbinger, vice president at HSH Associates, a publisher of mortgage and consumer-loan information. If inflation heats up, however, sharp interest-rate increases could follow. Adjusting to what might be a new era of rising rates means taking a fresh look at how you manage your debt, including mortgages, home-equity lines, and credit cards. Here's how various types of debt might be affected, along with tips on how you can best position yourself now:

MORTGAGES

If you're buying a home, it still makes sense to go with a fixed-rate mortgage even though rates have gone up, says Greg McBride, senior analyst with Bankrate.com, an aggregator of financial-product information. But fixed doesn't have to mean locking in for 30 years. If, like the majority of homeowners, you move every seven years or so, McBride recommends hybrid mortgages, which have fixed rates for the first several years (commonly 3, 5, 7, or 10), then convert to a variable rate. Rates on hybrids are 1 percent or more below the rates on 30-year loans.

If you already have a one-year adjustable-rate mortgage, consider refinancing at a fixed rate. "You want to avoid a rate adjustment in the next two or three years because those adjustments are likely to be fairly significant," McBride says. (For some examples of how high monthly payments can go if interest rates climb just a few percentage points in the next year or two--which is a reasonable assumption based on past trends--see the table below.)

Riskiest of all are interest-only ARMs, which are common in southern California and other areas where property prices have soared in recent years. "Lots of people bought more house than they could afford because they could swing monthly payments on interest-only adjustable-rate loans," says Howard Dvorkin, founder of Consolidated Credit, a credit-counseling agency. "If the Fed increases rates even incrementally, that monthly payment could double within three or four years and mortgage holders won't have any equity in the house."

If you have such a mortgage and can afford to switch to a fixed rate or hybrid--fees are typically 2 percent of your mortgage amount--consider doing it now.

HOME-EQUITY CREDIT

Home-equity lines generally have variable rates. You can switch to a fixed rate with a home-equity loan, but the rate gap between the two is big--in July 2003 fixed-rate loans were 2.25 percentage points higher than rates on home-equity lines.

"If you're borrowing a significant amount--say, $50,000 or more--for more than three years, you'd be better off locking in a fixed-rate home-equity loan," McBride says. For a smaller loan that you plan to repay in a few years, the credit line would be a better choice.

CREDIT CARDS

Whether you have fixed- or variable-rate credit cards, expect your rates to rise, warns Robert Manning, author of "Credit Card Nation." Minimize finance costs by making a list of all your cards and their rates and consolidating debt at the lowest rate. Just be sure not to put too much debt on one card. Carrying a balance that is 70 percent or more of your available credit can hurt your credit score. Shifting card debt to a low-rate home-equity line can be a smart option, but only if you're committed to paying off the debt and to avoiding getting in over your head again.

Monthly payments can get out of hand fast

Here are examples of loan payments at press time, and what they would be if rates were 1, 2, or 3 percentage points higher. "The larger the loan amount exposed to rising rates, the greater the pain," says Keith Gumbinger at HSH Associates, which publishes loan information.

Loan type and amount Monthly payment at current rate Plus 1% Plus 2% Plus 3%
$100,000
1-year ARM 		$492.58 $552.82 $616.36 $682.85
$50,000
Home-equity line of credit		 326.12 354.18 383.45 413.87
$10,000
Credit-card balance		 255.00 264.00 272.30 280.60
Note: Rates at press time averaged 4.26 percent for 1-year ARMs, 4.86 percent for home-equity lines, and 12.68 percent for credit cards. Calculations are based on a 30-year payout for ARMs, a 20-year term for home-equity lines, and paying 1.5 percent of an outstanding credit-card balance plus interest. Sources: HSH Associates, Federal Reserve