How Borrowers Should Handle Rising Interest Rates
As interest rates rise, find out the important financial decisions that borrowers need to make to save money.
For the past few years, interest rates have been at historic lows. However, as the economy and housing market perks up, the tide is turning and rates are creeping back up.
As interest rates rise, there are important financial decisions that borrowers need to make. I’ll tell you how to save money even as the economy heats up.
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What Happens When Interest Rates Rise
In order to understand how interest rates affect your finances, here’s some basic background about what happens when rates rise.
You probably already know that when interest rates go up, the cost to borrow money also increases. For instance, the monthly principal and interest payment for a 30-year, $200,000 mortgage at 3.5% interest is $898. But the same loan cost $1,013 if the interest rate goes up to 4.5%. You’ll pay $115 more per month for the same house if rates rise just 1%.
Certainly, no one likes to pay more interest for a home, car, or credit card than they have to. However, the upside to rising interest rates is that banks earn more from borrowers and can pay out more interest to savers. That means you can earn more interest on the money you keep in savings, money market accounts, and CDs.
Rising interest rates can also affect equity investments in a positive way. Since corporations form the backbone of the economy, interest rates typically go up when they’re doing well. Investors have the opportunity to share in their profits by owning stocks.
For instance…
…let’s say you buy 1,000 shares of company stock at $10 a share. If the stock price goes to $20 a share, you’ve doubled your money. You could sell the stock and pocket $10,000 before taxes.
This isn’t a complete description of the effects of interest rates in the economy because there are many factors at work. But my point is that rising rates don’t always have a net negative effect on your personal finances.
If you’re in the market to buy a big ticket item, like a car or house, try to speed up the process as much as possible. The faster you get approved for a mortgage, home equity loan, or car loan the better.
How Borrowers Should Handle Rising Interest Rates
One of the best ways borrowers can deal with rising interest rates is to lock in current rates as quickly as possible. If you’re in the market to buy a big ticket item, like a car or house, try to speed up the process as much as possible. The faster you get approved for a mortgage, home equity loan, or car loan the better.
When mortgage rates are ticking up daily, time is money. With a fixed-rate mortgage your interest rate and monthly payment can never change. So, if you plan to own a home for the long run, consider a fixed-rate loan that keeps your payment low, even while interest rates are climbing.
However, there’s still a place for an adjustable rate mortgage or ARM if you plan to sell the home within a few years or get really favorable loan terms. Just remember that your interest rate and monthly payments can go up dramatically if you can’t sell the property or refinance it down the road.
If you already have an ARM, review the terms to find out when and by how much your rate can go up. For example, an ARM might allow an interest rate adjustment every 6 months that can’t exceed 2% per year. Additionally there are caps on how much your payment amount can go up, such as 7% over the life of the loan.
See also: What Is the Best Type of Mortgage?
How Much Does It Cost to Refinance?
No matter if you have a fixed- or variable-rate mortgage, always crunch the numbers when interest rates are rising and see if refinancing can save you money.
You need to know the total cost to refinance and how much you’ll save each year. A typical refinance might cost anywhere from 1% to 5% of your outstanding loan balance. The fees to close a loan vary depending on the lender and the state where you live.
Consult with your lender or use a breakeven refinance calculator at sites like dinkytown.com and bankrate.com. They can show you how long you’d have to stay in your home to recover all refinancing costs by having a lower monthly payment.
For instance, if your closing costs are $3,000 and the deal will save you $300 per month, you’ll recoup your costs and break even after 10 months. If you’re sure you’ll own the home for at least a year, then you should probably refinance.
However, one situation where it may not pay to refinance is if you’ve had your current fixed-rate mortgage for a long time. By refinancing, you restart the amortization process late in your mortgage. This means most of your new payment will be comprised of interest and not paying down the outstanding balance.
So, in addition to considering the breakeven point of a refinance, consider the total amount of interest you’d have to pay if you refinance and if you don’t. If you’d pay the same amount or less interest doing nothing, then it isn’t worth the trouble to refinance.
Credit Cards and Rising Interest Rates
What about the effect of rising interest rates on credit cards? Although most credit card rates are tied to an economic index, they’ve stayed relatively high for some time, even though other rates were low.
Your credit score plays a big role in the rates you have to pay for consumer credit. So, depending on the type of card you select (such as a low-rate or rewards card), having excellent credit is the key to saving money on outstanding credit card balances.
You can learn more about smart strategies to raise your credit score in this free video tutorial: Credit Score Survival Kit.
Also, take advantage of 0% interest balance transfers cards when it’s right for your situation and pay off your credit cards each month to avoid interest and fees.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
