If your boss calls you into his office to tell you your pay is being cut by $500.00 per year you would not be happy. That is effectively what happens when interest rates go up and you are carrying debt with a variable interest rate feature. If the Federal Reserve were to raise interest rates by the end of this year, as the New York Times reported on August 30th, then the minimum payment required by many debt obligations could go up. This would reduce the money that you have for the other expenses of life so if you are carrying debt but managing to get by, you may need to make a change soon or face tougher financial choices.
Most consumers carry some amount of debt – whether it is a home mortgage, a credit card or a personal line of credit. Some of these loans enjoy a fixed rate of interest but many have variable interest rates. A fixed rate of interest is one that cannot be changed over the term of the loan. A variable interest rate can change based upon changes in a benchmark interest rate. If the benchmark rate goes up then the effective interest rate of the loan goes up. The New York Times article reported a projected interest rate increase of .25%. That may sound like a small number but it can have a big impact, especially when applied against large debt balances like home mortgages.
If you have a $250,000 mortgage with a variable interest rate, and that rate goes up by one quarter of one percentage point (0.25%) the monthly payment on your mortgage will go up by about $40.00 or nearly $500.00 per year. This is not small potatoes. Some people may have to cut down on their Venti Latte habit but for most people $40 a month has a real impact on their discretionary spending.
How can you tell if your loan has a variable interest?
For a credit card it is relatively easy, your monthly statement will disclose whether the rate is “fixed” or “variable.” For a mortgage loan statement it may not be so easy. If you kept your loan closing papers, then pull out the large legal sized envelope and find the “Note.” The Note is the loan document which describes the total amount, duration, monthly payment and interest rate of your loan. That Note will describe the interest rate as being fixed or variable. If the rate is fixed then it will be pretty easy to read. If the rate is variable, then it can be a nightmare of legalese to slog through to determine what the exact impact will be. If you are really struggling to work through the language, email me a PDF of the Note and I will help you parse through it.
What should you do if interest rates go up?
The first step of course is to take a close look at all your debt obligations and learn which have a variable rate feature. Even if you cannot afford to take the next suggested steps you owe it to yourself to learn about the interest rates on your loans. If you can afford it, try to retire that variable rate debt as quickly as possible by accelerating payments. If you have two credit cards carrying balances, one of which has a fixed interest rate and one of which has a variable interest rate, just make the minimum payment on the fixed rate card and pay as much as you can on the variable rate card. If you cannot afford to accelerate the payments, you may be able to move the debt from a variable rate loan to a fixed rate loan. This could be done through a balance transfer or perhaps obtaining a new fixed rate consolidation loan. If your home mortgage has a variable interest rate then you may want to explore refinancing to lock that rate in. If none of those options are available to you, then you may need to make some lifestyle/budgeting choices now to prepare for the burden of higher credit payments in the future.
We cannot accurately predict the future for interest rates, but knowledge of the details of your individual financial situation can help you prepare for and thus minimize the negative impact of rising interest rates.